China Crushes a Highly Lucrative Bond Trade in Just 30 Days

(Bloomberg) -- In December, China’s bond traders could buy sovereign debt with borrowed cash and net the best returns in almost seven years. Now they’re making next to nothing.

That’s largely down to the central bank, which is withdrawing cash from the interbank market after excess liquidity drove China’s overnight repo rate to a record low of 0.59%. Now the cost is near 3% -- the highest since 2015.

That’s not stopping the People’s Bank of China from tightening. On Thursday, authorities withdrew a net 150 billion yuan ($23 billion) of short-term funds from the financial system using open-market operations, the largest such amount since October. That came after the central bank unexpectedly mopped up medium-term liquidity earlier this month.

Repos -- short for repurchase agreements -- are used by banks and brokers to borrow from each other to cover short-term liquidity needs. But China’s financial institutions were using the funds to buy sovereign notes, generating quick and low-risk returns. The so-called carry trade was so popular earlier in January that daily turnover in overnight repos touched a seven-month high.

With China’s 10-year government bonds now yielding about 3.16% -- or just 16 basis points more than the overnight rate -- it leaves little room for traders to make money from the strategy. The gap was as wide as 263 basis points in late December.

China’s central bank drained medium-term cash from the financial system in January as it seeks to rein in the rapid buildup of leverage. The move coincided with surging demand for cash ahead of the Lunar New Year holiday, which created a mismatch in the interbank market and drove short-term money-market rates to multi-year highs.

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