China's Clumsy Yield-Curve Control Can Easily Misfire

8/14/2024 3:30:31 PM

(MENAFN- Live Mint) Just as
Japan declares victory over using government bond yields to set monetary policy and boost economic growth, China begins its own.

Yield-curve control, which aims to maintain yields at a certain level, is controversial. Since the bank of Japan started
the program in 2016,
bond market liquidity has evaporated. Last week's violent unwind of
yen-funded carry trades was another testament to how fraught it is.

It's increasingly clear that China is now trying to control its sovereign bond yields, too. In recent days, state banks
sold notes of different maturities, pulling rates higher. Brokers were guided to cut back on trading. Regulators have asked asset managers to report the duration of new bond fund products. Some rural banks were even told not to settle their sovereign note purchases.

These“window guidance” measures are meant to slow down a bear rally, especially in the long end. A weak economy, a lack of good investment opportunities, as well as bets of further central bank easing, have prompted households to pile into the space. The 10-year yield hit a record low of 2.1% on
Aug. 2, days after the People's Bank of China surprised markets with a benchmark rate cut.

Whereas Japan singularly focused on keeping its 10-year yield at“around zero,”
thereby abandoning other tenures to market forces, China seems to want more. It wants the entire yield curve to be well-behaved, where investors are still compensated for longer holding periods. In other words, no inverted yield curve, please. It's a bad omen,
if nothing else.

These interventions have prompted traders to speculate on the PBOC's tolerance levels. If the early August low was the threshold, then China would want the
10-
and 30-year yields to be at least 40 basis
points
and 60 basis points
higher than the benchmark 7-day reverse repo rate, according to Gavekal Research. That translates into 2.1% and 2.3%, respectively. Money managers may
not want to purchase more bonds if the floors are breached.

But how about a ceiling? There are now concerns
that the government's heavy-handed guidance
can backfire, resulting in an unintended spike in bond yields.

A massive redemption of bond mutual funds could be the transmission mechanism. Money has been flowing in this year, with assets under management increasing by 40%. Portfolio managers
have largely piled into long-dated bonds, which offer
higher yields. They net bought 947 billion yuan
, more than doubling the amount in 2023, according to research from Industrial Bank Co.

Those jumping onto this bandwagon in recent months are still seeing price gains. But the situation is fluid. Funds bought 10-year notes at an average 2.33% yield, only about 14
basis points higher than the current rate. If a few
rural banks decided to offload their holdings because they believed it was the new policy directive, a lot of mutual funds would be staring at losses, redemption requests, forced selling,
and some more losses.

A sharp jump in bond yields can be dangerous. In late 2022, after Beijing abruptly abandoned the Covid-Zero policy, leading to expectation of a growth boom, yields spiked. By December, more than one-fifth of wealth management products that invested in government securities and high-quality commercial paper
“broke the buck,”
reporting assets worth less than their face value. Chinese savers fled.

While the jury
is still out on whether the BOJ's unconventional monetary policy has been
successful, at least Japan has been transparent and bought bonds to keep the 10-year yield within a favored range. China, on the other hand, has not made any public commitments, relying on whispers and behind-the-door admonitions to traders
instead of open market operations. Its credit
market will end up losing liquidity a lot faster than Japan's.