China Bonds Dive as Investors Take On More Risks

China’s bond investors are getting antsy again.

The latest selloff of Chinese government debt was triggered by a better-than-expected economic outlook from central bank governor Zhou Xiaochuan on Sunday, as well as his warning about lingering risks in the financial system, traders and analysts said.

On Wednesday, yields on China’s 10-year government debt closed at 3.736%, after climbing to 3.741% on Tuesday, the highest since December 2014. Yields of the most actively traded sovereign debt closed at 3.67% on Friday, prior to Zhou’s comments.

“We believe it is a short-term bond market reaction to economic fundamentals that beat expectations, which has thrown cold water on hopes for looser regulations and monetary policy,” said Liu Dongliang, senior analyst at China Merchants Bank.

Zhou told a bankers’ group in Washington that the world’s second largest economy could expand by 7% in the second half of this year, with consumer spending as the main growth engine. It was a surprising prediction considering the economy grew 6.9% in the first half, surpassing GDP growth of 6.7% in 2016.

Traders said there were at least two forces behind the current yield spike.

First, the market had widely expected the economy to expand more slowly in the second half, so Zhou’s projection was a surprise. The news encouraged investors to take more risks, leading some funds to flow from “safer” bonds into “riskier” equities. “Market participants didn’t expect a major boost in economic growth, amid tighter regulations aimed at heading off financial risks … But now, better economic indicators may have changed their outlook,” a bond trader at a joint-stock bank said.

China’s third-quarter GDP data, due out Thursday, will be closely watched as a key gauge of the country’s economic outlook.

Secondly, as Zhou said, the government will take proactive actions to rein in lingering systemic risks and cut excess leverage in the second half, which some traders believe will keep liquidity just as tight as it was in the first half, draining cash from the bond market.

China Merchants Bank’s Liu suggested that it is unlikely that the central bank will roll out more expansionary policies this year to increase liquidity, considering the selective cut to banks’ reserve requirement ratios that will kick in early next year.

But some still believe China’s economic growth will remain sluggish in the near term.

“It is quite certain that both property sales and investment will cool down, and that manufacturers and companies will halt the latest restocking cycle,” Liu said. “Plus, local government financing may be kept on a tighter leash, which could limit investment in infrastructure construction.”

“If the economic data for the third quarter released on Thursday can ease bond investors’ anxiety and boost their confidence, the bond market could regain its strength,” China International Capital Co. wrote in a research note.

Contact reporter Dong Tongjian (tongjiandong@caixin.com)