Following yesterday’s violent selloff in bonds, which has continued today across the globe, one country that was particularly impacted was China, where as we reported overnight, Chinese government bond futures plunged by the most on record, dropping by 2% in the session, and erased in a week the gains of the past 18 months, hitting a 16 month high yield of 3.4%.
The crash happened just two weeks after we warned that as a result of the PBOC’s imprudent recent tightening of financial conditions, the central bank was practically begging for a bond market crash, one which Janet Yellen was happy to catalyze with the Fed’s rate hike and hawkish language. As the chart below shows, a crash is precisely what China got.
The crash, however, was just the start of China’s woes, because what happened next could spell far more headaches for a market that is now in a “bursting bubble” mode. As the WSJ reported this morning, Chinese authorities halted trading in key bond futures for the first time on Thursday, “as panicky investors sold the securities on concern that a long, credit-fueled bull market was coming to an end amid slowing growth, capital outflows and heightened government concern about asset bubbles.”
After China’s 10-year Treasury bond future crashed by 2%, the biggest daily drop in history, exchange authorities had no choice but to suspend the securities to avert a selling panic. Trading resumed only after China’s central bank came to the rescue – as it always eventually does – injecting $22 billion into the short-term money market. The furious selloff, captured in the chart above, began in late November and has accelerated this week on concerns of capital outflows, a hawkish Fed and rising inflationary pressures.
As is widely known by now, China years of abundant, cheap credit have lead to a series of price bubbles in various asset classes from housing, to stocks, to commodities, to cars, to chickens, and now bonds. Many of these bubbles have burst dramatically over the last 18 months, with the crash in China’s stock markets last summer the most notable example.
However it was only last week, when on Thursday the pain spread to China’s $9 trillion bond market, which remains overwhelmingly driven by domestic investors, despite some opening up to foreigners this year. As we reported as the time, the yield on 10-year government bonds had reached a record low of 2.6% in August.
In an amusing comment shared by the WSJ, Hao Hong, co-head of research at Bocom International said that “People woke up to the fact that the bond bubble is too large. The bond market in China is under severe pressure, across the board.”
As was to be expected, and as this website warned in November, the Fed’s decision to raise interest rates helped trigger the selloff. Chinese investors believe it increases the chance China will guide its own rates higher to stem the yuan’s recent decline against the dollar and heavy capital outflows from the country. However, unlike other EMs, China has its own unique set of problems to deal with. The local bond market slump also exacerbates the policy dilemma facing China’s central bank which as we explicitly warned less than a month ago in “The Market’s Next Headache: China’s (Not So) Stealth Tightening” tightened short-term lending in recent weeks in an effort to make it harder for speculative investors to borrow money. The problem is that such tightening moves—along with any future rate rises—could provoke market plunges and panics as liquidity dries up.
“The Chinese bond bull market is over, as we have seen a turning point in money market rates this year,” said Yang Delong, chief economist at Shenzhen-based First Seafront Fund Management Co., with $6 billion under management, referring to a tightening of liquidity in China that began this autumn and has recently gathered pace.
There was more.
As the WSJ adds, Thursday’s selling pressure was also driven by rumors spreading through the markets that a midsize Chinese brokerage had defaulted on a large bond payment, which it later denied. One of the country’s biggest fund managers, meanwhile, denied a rumor circulating on cellphone chat groups that it was facing large redemptions. Analysts said such rumors carried weight because many fund managers are heavily in debt, making them vulnerable to declining bond prices.
“The market is very sensitive to rumors now,” said Ke Congwei, a fixed-income analyst at Guosen Securities, based in Shenzhen.
Which is not good, because it means last night’s crash is just the start and will add to broader concerns about the Chinese economy, which grew at its slowest pace in more than 25 years in 2016, weighed down by a growing debt load and money-losing state-owned industries. Adding to China’s mysery is that the country has been grappling with large-scale capital outflows. The country has lost around $1.2 trillion of its foreign reserves, or around a quarter of its total, in the last two years as billionaires and average citizens transfer savings to the safety of overseas markets. To stem the outflows, authorities are using measures such as restricting overseas company acquisitions—transactions that could be fronts for spiriting money out of the country.
But the worst news is that in an economy driven entirely by cheap, abundant credit, at least until now, the consequences of the bursting of the bond bubble will only emerge in the coming weeks as China’s economy, all of which is vastly reliant and lubricated by said cheap credit, slows down dramatically, and which in turn will spillover to both the global economy and capital markets. The only question is when.