China's big bond market run may come to an end. The market faces an uphill battle after the yields of 10 year government bonds peaked at 18 month highs of 33.3 percent during the second week of December. There was even a short suspension of the 10 year government bond futures. This was done after the fall exceeded the two percent limit per day. It was the first suspension from the time the futures got relaunched in 2013.
Role of the Federal Reserve
The market was spooked by the indications from US Federal Reserve that there is the possibility of the central bank tightening its fiscal policy in 2017. It may even happen sooner than expected. China is placed in a tough position if there is a rate increase by the Feds. The pressure of capital outflow will put pressure on the exchange rate of Renminbi.
It is to be kept in mind that the probable action by the Federal Reserve is only one of the causes. Investors face a number of challenges. The most prominent among them are a better macro outlook, PboC move and capital outflows. All these gave rise to a bond bubble. This happened as investors had literally poured money into bonds. It did not help as this was made easier by the presence of cheap cash flooding the financial system. Yields from Chinese government bonds dropped to 2.65 percent in October 2016 from about 4.6 percent in the beginning of the year-January 2014.
With the 10 year government yield of China continues to be at a high of 3.28 percent on December 19, the market seems clearly a volatile one. Similar to concerns about US Treasury market, there are serious concerns about inflation. The latter pressure the prices of bonds and jacks up the yields. Commodity prices have rebounded due to higher demand from the Chinese industrial economy. Inflation again dominates the financial scene. The producer price index of the economy was in the negative territory for about four successive years until August. The PPI went up to 3.3 percent within November- the quickest pace within a period of five years.
For its part, the PboC has crafted a gradual tightening of liquidity in the money market from the summer of 2016. The repurchase rate of overnight bonds has an average of 2.26 percent until December. This can be compared with a meagre 2.02 percent in August. Bond investors are frightened by higher interest rates and thus they trimmed their holdings. The carry trade also lost its sheen.