China’s Bond Traders Reprice a Future With Tighter Liquidity

(Bloomberg) -- Chinese financial markets are adjusting to a new normal: the central bank will go to considerable lengths to reduce the risk of asset bubbles.

The People’s Bank of China tightened liquidity in the financial system and drove up rates in the money market in January. The move, which initially shocked markets, suggests that an era of cheap and plentiful funds has ended. Six out of seven analysts surveyed by Bloomberg predict the central bank will refrain from offering medium-term funds before next week’s Lunar New Year holiday, a reversal of what it did in the prior two years.

Pricing in that shift has been especially painful for leveraged bond traders, who benefited from borrowing cheap cash to buy government bonds. The returns made on that so-called carry trade were slashed by half within a month and were briefly negative. A tool used by traders to finance bond purchases saw volume shrink about 70% in three weeks.

The PBOC has sought to avoid stoking frenzied investments that risk inflating asset bubbles, which could undermine the country’s economic recovery. Signs of too quick a buildup in leverage began to emerge last month, when margin debt in stocks jumped and volume of the interbank funding tool -- known as overnight repurchase agreements -- soared.

“Investors are pricing in rather tight liquidity in the first quarter,” Xing Zhaopeng, an economist at Australia & New Zealand Banking Group. “They will have to keep reducing leverage.”

The central bank mopped up 217 billion yuan ($33.6 billion) from the financial system last month, compared with cash injections during the same period in both 2020 and 2019. In the previous two years, the PBOC also released cheap, long-term funds by cutting the amount of cash lenders need to keep in reserve before the holiday.

Last month’s cash squeeze pushed the overnight repo rate -- a key gauge of the price of loans banks charge each other -- to a six-year high of 3.3433%, surpassing China’s 10-year sovereign yield. That means the PBOC effectively crushed the red-hot strategy for traders to borrow through repos and buy bonds.

Cash needs typically spike ahead of the Lunar New Year as companies load up funds to pay workers and consumers spend heavily on gifts and travel. Though demand this year could be weaker because of China’s travel restrictions to contain a virus resurgence, analysts say the central bank needs to inject as much as 1 trillion yuan to help banks handle the liquidity shortage.

However, while the PBOC spooked investors with the cash squeeze, it’s not engineering a major liquidity crunch that could choke the money market. The central bank resumed adding cash, net pumping 194 billion yuan in to the financial system in the past five sessions. The overnight repo rate fell in three out of four days this week.

Still, market observers don’t expect a return to the ultra loose liquidity seen at the end of last year. The PBOC will offer just enough to meet lenders’ demand for cash in the lead-up to the Lunar New Year holiday, said Becky Liu, head of China macro strategy at Standard Chartered Plc. Instead of injecting one-year funds, Beijing will mostly add liquidity with 14-day reverse repo agreements, which will mature after the week-long break, she added. The holiday begins Feb. 11.

Further into this year, China will keep liquidity tight, according to ANZ’s Xing. That’s because Beijing needs to stabilize a rapid build-up of debt in the economy last year as households and corporates increased borrowing.

“The anticipation on short-term easing has died down,” said Liu. “Given the great effort the central bank invested in turning around investors’ expectations on easing, I don’t think it will take any actions that could be regarded as loosening signals in the near-term.”

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