PBoC bond plan raises expectations for yield-enhancing measures

The People’s Bank of China (PBOC) has taken action to slow a bond rally that has led to record low yields. This initiative may temporarily stabilize the market, but analysts expect a significant change in investors’ preferences for these securities will only occur once confidence in the economy is restored. (Section. 1).

On Monday, the PBoC announced its intention to borrow government bonds from primary dealers – financial institutions authorized to trade securities with the government – to ensure the stable and healthy operation of the bond market. The underlying expectation is that the PBoC will eventually dump these borrowed bonds on the secondary market to curb the bond-buying boom and raise government bond yields to levels deemed appropriate by the central bank. (Section. 2).

Investor interest in Chinese government bonds has surged due to uncertainty about the country’s economic recovery, low bank savings rates and expected further rate cuts. This intense buying activity has pushed bond prices up significantly while reducing yields. The yield on the 10-year government bond fell to a historic low of 2.18% before the PBoC’s announcement. (Section. 3).

The PBoC has warned of the risks of buying bonds with borrowed funds, pointing out that it increases market volatility and has the potential for significant losses if market conditions change. The central bank believes that yields on long-term government bonds are currently too low. (Section. 4)(Section. 5). Analysts say concerns about the exposure of financial institutions to government bonds, particularly insurers that hold large amounts of long-term bonds, are a likely reason for the PBoC’s decision. Significant losses for these institutions could pose risks to financial stability similar to those posed by the collapse of Silicon Valley Bank (SVB), which suffered a dramatic decline in asset values ​​due to rising market interest rates. (Section. 5)(Section. 6).

Strategies aimed at short-term gains, such as those used by mutual funds, can amplify risks. If bond prices fall, these institutions could quickly sell their holdings, exacerbating the price decline. (Section. 7).

Despite the PBoC’s brief statement, it is widely expected that the central bank will sell the borrowed bonds on the secondary market in order to get the falling government bond yields under control, at least for the short term. (Section. 8th). Analysts at Yuekai Securities Co. Ltd. said the selling could push yields back up to a range of 2.5 to 3 percent, compared with China’s potential growth rate of 5 percent. Current yields on long-term government bonds have fallen below that range. (Section. 9).

To have a noticeable impact on interest rates, the PBoC may need to significantly expand its bond sales, possibly in the tens of billions, say analysts at Huatai Securities Co. Ltd. Smaller sales under 10 billion yuan would likely serve as guidance for the market rather than have a significant effect. (Section. 10).

In the longer term, analysts such as Wei He of Gavekal Dragonomics argue that a sharper rise in bond yields will require significant improvements in economic fundamentals. Persistently loose liquidity conditions and slowing credit growth suggest weak credit demand, leading financial institutions to opt for government bonds, thus keeping yields low. Reversing the downward trend in long-term bond yields will require significant fiscal and monetary support measures. (Section. 11)(Section. 12).

AI generated, for reference purposes only