China Money: Bond curve may have steepened enough

SHANGHAI, Dec 8 - China's bond yield curve has steepened spectacularly in the last few months as the central bank has flooded the money market with funds. But short-term yields are now so low that the curve may flatten back moderately.

The spread between the indicative one-year government bond yield and the 20-year yield ballooned to a multi-year high of 218 basis points on Monday from just 67 bps two months ago, Reuters Reference Rates show.

There were good reasons for the steepening. On Friday, a big cut in commercial banks' reserve ratios took effect as the central bank eased quantitative policy, seeking to stimulate corporate lending by pushing down banks' cost of funding.

And in order to inject even more money into the market, the central bank has suspended new issues of one-year bills and sharply cut back sales of three-month bills, leaving the market starved of high-grade, short-term debt.

Meanwhile, a big fiscal stimulus package announced in November is expected to be financed partly by an increase in government bond issues, focused in the long end of the curve.

UBS estimates issuance of government bonds with tenors of 10 years and above could reach 490 billion yuan ($71 billion) in 2009, against 207 billion yuan in the first 11 months of 2008.

DESPERATION FOR YIELD

But some traders and analysts are starting to think the market has fully digested these factors, and that in their desperation for yield as the economy slumps, investors will have to go back into long-term debt.

"Short-term yields are so low now and investors are seeing central bank bills, which accounted for half of their investment, maturing without new issuance to replace them," said Fan Xiulan, fixed income analyst at Bank of China International.

"Investors, especially banks, will have no choice but to put more of their money into long-term bonds."

The spread between one-year and 20-year maturities has reached its widest level in over three years; it swelled 33 bps on Monday alone, exceeding its previous peak of 196 bps hit in June 2007.

At that time, annual consumer price inflation was running at 4.4 percent; such a steep curve may not make sense when analysts are talking about the possibility of deflation early next year.

If long-term government bond issuance does increase, it seems unlikely to do so immediately. Because of the way the government's cash management process works, the first quarter of each year tends to be a light one for bond issuance.

In the past five years, the first quarter has accounted for only about a fifth of the year's total issuance, with almost no bonds being issued in the month of January. That pattern is not expected to change much in 2009.

BACK UP THE CURVE

And yields on the shortest-term bonds are now looking extremely low to many traders. On Friday, the finance ministry auctioned one-year bonds at a yield of 1.28 percent.

That was 21 bps below the median market forecast, and fully 57 bps below the weighted average seven-day bond repurchase rate, a key funding rate for banks and other investors.

Traders agree the seven-day repo, last at 1.85 percent, has room to fall further in coming weeks and months as the central bank continues easing policy.

Many traders expect the repo to slide to 1.0 percent or a bit lower in the first half of 2009; the interest rate on excess reserves placed with the central bank is 0.72 percent.

But that would still leave relatively little room for further falls in the one-year bond yield in the secondary market, which was indicated at 1.4178 percent bid on Monday, down 215 bps over the last four months.

Any a slowing of the one-year bond yield's slide could alert more investors to trading risks in that area and push buyers back up the curve.

A trader at a major Chinese life insurer said that while limited liquidity in long-term bonds would remain a worry, the curve could stop widening, and narrow back modestly, at any time.

"The one-/20-year spread could narrow 10 bps from current level within a month," she said.

China International Capital Corp said in a report on Monday that 10-year bond auctions by Agricultural Development Bank of China this Tuesday, and by the finance ministry this Friday, could provide cues for the curve to start flattening. ($1 = 6.88 yuan)