Quarterly Outlook
Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?
John J. Hardy
Global Head of Trader Strategy
Why Chinese government bonds are crucial
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The moment for which many people have been waiting is finally here: Saxo Bank is releasing Bond Connect.
The Saxo platform will give institutional clients the opportunity to trade Chinese onshore government bonds, central bank paper and much more, putting clients in direct contact with counterparties providing liquidity on Bond Connect.
This means that Saxo Bank’s institutional clients will be able to access a market long closed to foreign investors, as well as one that is destined to see activity increase dramatically as international investors come to understand the importance of the Chinese bond market, and Chinese government bonds in particular.
Chinese government bonds were one of 2018’s best-performing sovereigns. The yield on the 10-year CGB has plummeted from 3.9% at the beginning of 2018 to near 3% at the beginning of 2019, amid December’s equity sell-off, tighter global financial conditions, and rising political uncertainty due to the Sino-US trade war, among other factors.
The behavior of CGBs throughout last year demonstrates that these sovereigns are assuming a safe-haven role. In a period where we believe that volatility is going to rise as we get closer to recession, these sovereigns can provide a nice buffer within a diversified portfolio.
Another thing to note is that the Chinese sovereign yield curve has steepened considerably within the past year, where we saw a “bull steepener” in which short-term yields fell faster than their longer-term counterparts.
Short-term yields have been pushed lower due to the current economic and political uncertainty. This is a signal that investors are forecasting further unrest. This takes away some of the convenience of being invested in short maturities, especially as US Treasury yields in the short part of the curve are somewhat comparable. In fact, while the two-year CGB offers a yield of 2.61%, the two-year Treasury offers 2.51%, just 10 basis points off the CGB.
This means that Saxo Bank’s institutional clients will be able to access a market long closed to foreign investors, as well as one that is destined to see activity increase dramatically as international investors come to understand the importance of the Chinese bond market, and Chinese government bonds in particular.
Chinese government bonds were one of 2018’s best-performing sovereigns. The yield on the 10-year CGB has plummeted from 3.9% at the beginning of 2018 to near 3% at the beginning of 2019, amid December’s equity sell-off, tighter global financial conditions, and rising political uncertainty due to the Sino-US trade war, among other factors.
The behavior of CGBs throughout last year demonstrates that these sovereigns are assuming a safe-haven role. In a period where we believe that volatility is going to rise as we get closer to recession, these sovereigns can provide a nice buffer within a diversified portfolio.
Another thing to note is that the Chinese sovereign yield curve has steepened considerably within the past year, where we saw a “bull steepener” in which short-term yields fell faster than their longer-term counterparts.
Short-term yields have been pushed lower due to the current economic and political uncertainty. This is a signal that investors are forecasting further unrest. This takes away some of the convenience of being invested in short maturities, especially as US Treasury yields in the short part of the curve are somewhat comparable. In fact, while the two-year CGB offers a yield of 2.61%, the two-year Treasury offers 2.51%, just 10 basis points off the CGB.
Comparing CGBs and Treasuries, investors might be concerned that the yield pickup in CGBs is very low. However, investors should bear two very important factors in mind:
1. The People’s Bank of China may want to intensify its easing efforts. At the moment, there are ongoing talks on how the Chinese government might stop an economic slowdown. Until now, the PBoC has injected extra liquidity into the banking system in the hope that the banks would lend to the small- and medium-sized enterprises that have suffered most from the trade war.
However, banks have not been able to lend as much as desired due to concerns about high debt levels and credit quality among borrowers; most of the time, they simply buy bonds in the financial markets. Market participants are wondering whether the PBoC will need to expand its easing efforts in order to avoid a deepening crisis.
Although the PBoC is banned from buying government bonds, leading many to believe US-style QE is impossible in China, we believe that it will seek to walk that path if necessary. Before that point, though, the bank will try to make its existing monetary policy more effective. Either way, we can expect PBoC measures to support the bond market’s valuation pushing CGB yields lower.
2. There might be some upside in holding renminbi against USD. The US dollar is still trading at a 15-year high, and with the US on an easing path we can expect the dollar to correct. At the same time, it is in China’s interest to keep the renminbi stable to avoid chaotic devaluations and to continue to attract capital.
Although it seems as though CGB have rallied significantly with only a little room for further appreciation, investors should consider the above while keeping in mind that foreign investors gaining more and more access to a previously closed market will play in favour of CGB holders.
In April of this year, the Bloomberg Barclays Global aggregate index will include CGBs and policy banks’ bonds and onshore Chinese sovereigns will represent the index’s fourth-largest currency component in the index after the US dollar, the euro and the Japanese yen. CGBs are on track to becoming a fundamental component of clients’ portfolios and investors should embrace them.
1. The People’s Bank of China may want to intensify its easing efforts. At the moment, there are ongoing talks on how the Chinese government might stop an economic slowdown. Until now, the PBoC has injected extra liquidity into the banking system in the hope that the banks would lend to the small- and medium-sized enterprises that have suffered most from the trade war.
However, banks have not been able to lend as much as desired due to concerns about high debt levels and credit quality among borrowers; most of the time, they simply buy bonds in the financial markets. Market participants are wondering whether the PBoC will need to expand its easing efforts in order to avoid a deepening crisis.
Although the PBoC is banned from buying government bonds, leading many to believe US-style QE is impossible in China, we believe that it will seek to walk that path if necessary. Before that point, though, the bank will try to make its existing monetary policy more effective. Either way, we can expect PBoC measures to support the bond market’s valuation pushing CGB yields lower.
2. There might be some upside in holding renminbi against USD. The US dollar is still trading at a 15-year high, and with the US on an easing path we can expect the dollar to correct. At the same time, it is in China’s interest to keep the renminbi stable to avoid chaotic devaluations and to continue to attract capital.
Although it seems as though CGB have rallied significantly with only a little room for further appreciation, investors should consider the above while keeping in mind that foreign investors gaining more and more access to a previously closed market will play in favour of CGB holders.
In April of this year, the Bloomberg Barclays Global aggregate index will include CGBs and policy banks’ bonds and onshore Chinese sovereigns will represent the index’s fourth-largest currency component in the index after the US dollar, the euro and the Japanese yen. CGBs are on track to becoming a fundamental component of clients’ portfolios and investors should embrace them.
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