An (almost) inverted yield curve is worrying China

An asset famine is driving risk-taking among China’s investors. (Source: Bloomberg)

A curious thing is happening in China’s 29 trillion yuan ($4 trillion) government bond market.

The yield differential between 30- and 10-year bonds has narrowed to as little as 11 basis points, sparking discussions over whether some parts of the sovereign curve will invert too, like it did in the US.

The yield curve may be getting flatter because of temporary market dynamics, not fundamentals. Much of the compression came from a strong rally in ultra-long notes. The 30-year is offering only 2.4 percent, an almost 1 percentage point drop from a year earlier. It’s even lower than the 2.5 percent one-year loan rate at which the People’s Bank of China lends to big financial institutions.

Spooked by a January stock market rout, households pulled money out of equities and poured their savings into bond funds, whose solid returns turned out to be a bright spot. Meanwhile, a slowdown in new offerings
from higher-yielding local government financing vehicles is pushing asset managers to purchase more ultra-long sovereign notes in order to juice up their portfolio returns.

Whatever the reason, an inverted yield curve has a bad rap. In normal times, notes with longer maturities offer higher rates to compensate lenders for tying up their money for an extended period. When those yields sink close to or below shorter ones, it’s an indication that investors are pessimistic about an economy’s growth prospects. In the US, an inversion was a reliable predictor of recessions, at least in the pre-pandemic days.

In addition, this level of yield compression showcases the extent of what the Chinese call an “asset famine,” when record-low interest rates, dismal stock returns and a property downturn are causing a shortage of high-yielding assets, so much so that investors are discarding duration risk.

This asset famine has led to other excessive risk-taking behaviors. The appetite for better-performing overseas equities is running so high that it’s fueling huge price distortions in onshore funds tracking these assets. For instance, in January, investors were paying more than a 20 percent premium to net asset value for shares in an exchange-traded fund that followed Japan’s Nikkei 225. This ETF still trades at an elevated 6 percent premium. Meanwhile, state media is renewing warnings on cryptocurrency trading, which is banned in China. People have been rushing into Bitcoin through underground exchanges, where consumer protection is scarce.

But can you blame mom-and-pop investors? These days, holding a 30-year bond doesn’t even yield 3 percent. It’s disorienting for a nation of savers who were easily able to get that rate from plain-vanilla bank savings accounts just a decade ago.

At the annual legislative meeting last week, Premier Li Qiang outlined a proposal to issue 1 trillion yuan of ultra-long special central government bonds this year, with more to come. It’s killing two birds with one stone. Not only is Beijing using the proceeds to boost fiscal efforts, but supply on the long end is also increased so the yield curve doesn’t tip over. At the same time, regulators are scrutinising regional banks’ bond investments for any speculative activities.

In Beijing, there are a few economic taboos. Deflation is one — the government is still targeting 3 percent consumer inflation this year, even though empirical evidence is mounting that the economy is at a minimum slipping into disinflation. An inverted yield curve is another. It’s an ominous sign that many in China are fearfully anticipating a prolonged period of stagnation.

Shuli Ren is a Bloomberg Opinion columnist. Views do not represent the stand of this publication. 

Credit: Bloomberg