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Surging Dollar Upends China's Huge Bond Market

The People's Bank of China injected liquidity into the short-term money market after the U.S. Federal Reserve’s signals on interest-rate increases next year worsened a global bond selloff.
ENLARGE

The People’s Bank of China injected liquidity into the short-term money market after the U.S. Federal Reserve’s signals on interest-rate increases next year worsened a global bond selloff.


Photo:

Associated Press

By

Nathaniel Taplin

Dec. 16, 2016 6:54 a.m. ET

China’s bond market looks to have taken a tough blow from the Federal Reserve rate increase. It might not lead to a prolonged credit crunch like what paralyzed China’s markets in 2013. But it is a sign that higher rates are here to stay in China, too.

Rates in Shanghai blew out Thursday after the Fed decision, forcing a trading halt and a major liquidity injection from the central bank to bring rates back into line. Trading was somewhat smoother Friday, but the key 7-day repo rate continued to inch up, and authorities felt compelled to inject another slug of cash.

China’s money markets matter because they have served as a springboard for a flood of short-term lending over the past year, some directly into the economy, and some directed back into leveraged bets into the bond market. But these markets are also exposed when the central bank buys yuan to prop the currency up against a surging dollar, essentially sucking domestic cash out of the system.

Things might have been worse if the People’s Bank of China’s pre-emptive moves to curtail such risky overnight lending this summer—which triggered the last big selloff in government bond futures—had not already squeezed substantial leverage out of the system.

Overnight bond repo volumes on a weekly basis have dropped by around 40% since their mid-July peak, and are now running at the same level as in mid-2015, before the enormous bond issuance bonanza of the past year and a half. Levels are still far higher than 2014, but clearly some players have already pared big leveraged bets on bonds, providing some limited inoculation to the market now.

That said, real borrowing costs for many firms are now clearly rising, after a sharp fall over the past year which helped repair balance sheets and staved off further market dislocations. The government said in a statement after its economic work conference Friday, an annual policy setting meeting, that monetary conditions could be less accommodative and warned it would need to take action against asset bubbles: “The house is for living, not for speculation.”

Chinese data released Wednesday showed that nonbank “shadow finance”—usually more expensive than conventional lending—was nearly 30% of net new credit extended in November. That is the highest proportion in a year and a dramatic shift from a net contraction in shadow finance as recently as October. With bond yields rising and bank lending growing slower than midyear, borrowers appear to be turning back to the slippery shadow banking system for funding.

If the Fed follows with more rate increases next year, China’s bond markets should keep feeling the pain.

Write to Nathaniel Taplin at [email protected]

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