In the bond market, an inverted yield curve has often predicted recession in developed economies. So what does the recent inversion of the yield curve in China say about the country’s economic outlook?
Since 2005, the yield on the 10-year Chinese government bond (CGB) has exceeded the one-year CGB yield by an average of 100 basis points (bps). An upward-sloping yield curve of this sort is normal in the $3.5 trillion CGB market and, as in most countries, reflects expectations for future policy rates, a term premium and healthy market supply-demand dynamics.
But on 7 June, the 10-year CGB yield sank below the one-year yield. This yield curve inversion has occurred only once before, in June 2013, amid a severe liquidity crunch in the interbank market.
What is causing the current yield-curve inversion? We see four main drivers:
The People’s Bank of China (PBOC) has tightened monetary policy since the fourth quarter of 2016 to curb an asset bubble, mitigate financial leverage and support the yuan. Since the end of the third quarter of 2016, the 10-year CGB yield has risen 85 bps to 3.59%, and the one-year yield has risen 145 bps to 3.62%.
The PBOC hiked the seven-day reverse repo rate twice – by a total of 20 bps, from 2.25% to 2.45% – since the fourth quarter of last year. The PBOC’s liquidity-draining operation lowered the system’s excess reserve ratio from 2.4% at the end of 2016 to only 1.3% by the first quarter of this year – the second-lowest on record.
Wholesale funding, which accounts for a quarter of banks’ liabilities, has tightened sharply, and benchmark three-month negotiable certificate of deposit (NCD) rates have surged 220 bps to 5.1% since PBOC tightening began late last year. NCDs are the main interbank money market instruments and account for 3% of banks’ liabilities, thus setting most banks’ marginal funding costs.
There has been renewed regulatory pressure on banks to unwind their leveraged bond portfolios both on and off their balance sheets, which partly explains the severity of the sell-off.
Broader meaning: Signs of pressure
What does the yield-curve inversion mean for the Chinese economy?
The PBOC has clearly tightened monetary conditions, pressuring banks to curb corporate and mortgage lending while passing through higher lending rates to borrowers. Chinese growth – particularly nominal growth – clearly peaked and should decelerate into 2018. Historically, a flattening and inverted yield curve has indicated weakening industrial production with a lag of five months, as shown in the chart below.
China’s reflation momentum is also turning. The surge in producer prices from upstream commodities faded during the second quarter, and tight liquidity is expected to weaken construction demand and create some destocking pressure, particularly in commodities such as iron ore.
On the margin, China’s monetary tightening and financial deleveraging will be a headwind to a rebound in global manufacturing and reflation in commodities.
For Chinese policymakers, maintaining macro stability, particularly financial stability, in the $10 trillion bond market is of paramount importance. A delicate balance needs to be maintained between curbing excess leverage and maintaining financial stability. A persistent wholesale funding squeeze and yield-curve inversion in a relatively opaque and interconnected financial system are signals of strain; they should be taken seriously by both policymakers and investors.
For more on China and our growth outlook, please read, “A Less ‘Impulsive’ China: Bracing for Lower Growth.”
For our long-term views on China and the global economy, see our 2017 Secular Outlook.
Isaac Meng is an emerging markets portfolio manager with a focus on macroeconomic and financial analysis of China. He is a frequent contributor to the PIMCO Blog.