China Money: Bond curve to steepen further as policy shifts

By Karen Yeung

SHANGHAI, Oct 31 (Reuters) - After flattening for two months, China's bond curve has entered a steepening trend that may have much further to run in coming months as the outlook for monetary and fiscal policy points to a shift in the bond supply mix.

In the two months to early October, the spread in the secondary market between the one-year government bond yield and the 10-year bond yield shrank 68 basis points to 27 bps, its lowest in at least two years, Reuters Reference Rates show.

During that time, long-term bond yields tumbled as traders bet that slowing growth would force the central bank to cut official interest rates.

At the same time, short-term yields were propped up because the central bank was aggressively issuing one-year bills in its open market operations to drain market liquidity.

Since early this month, however, the spread began widening as those conditions reversed.

Monetary easing has become more fixed into market pricing, with the central bank on Wednesday announcing its third rate cut in six weeks.

And in open market operations, the central bank let the one-year bill yield tumble 50 bps this month, while substantially scaling back the volume of one-year bill issuance, via bi-weekly instead of weekly sales.

At the long end, investors have become more cautious. One reason is that a growing number of analysts expect a substantial expansion in supply of long-term bonds to fund fiscal stimulus measures.

"China's yield curve may steepen in coming months, with the short-end falling sharply because of the central bank's change in open market operations," said Qu Qing, analyst at Shenyin & Wanguo Securities.

SHORT END

The central bank's cut in one-year bill issuance, many traders say, reflects its drive to boost liquidity in the money markets, in order to bolster corporate lending, and this will depress yields at the short end of the yield curve.

They also believe the central bank has become reluctant to lock up funds via its open market operations for long periods and will prefer to rely instead on drains via three-month bills and short-term bond repurchase agreements, to gain flexibility.

The central bank has become notably more generous with funds in its open market operations this month.

Including money injected from the latest two cuts in banks' reserve requirement ratios, it conducted a net injection of 92 billion yuan for October, a reversal from net drains of 192 billion yuan for September and 106.5 billion yuan for August.

Another indication that liquidity may gradually loosen is the decline in the seven-day bond repurchase rate, a key measure of short-term liquidity that has steadily fallen from a two-month high of 3.7281 percent early this month to 2.7900 percent, its lowest since mid-August.

Traders think it may gradually fall to about 2.70 percent in coming weeks.

The cut in one-year bill issues may halve next year's supply of such bills from about 2.1 trillion yuan ($307 billion) issued in the past 12 months.

Some traders are even more bullish at the short end, believing that the central bank will gradually phase out the issuance of one-year bills entirely.

"The one-/10-year bond spread may widen about 30 bps by the end of the year, with the one-year yield hitting nearly 2.2 percent," said an analyst at a major Chinese bank in Beijing. The one-year bond yield was last at 2.6190 percent bid.

LONG END

Long-term bond yields, however, may drop more slowly.

A government fiscal stimulus package next year to bolster the slowing economy is expected to involve issuance of government construction bonds with tenors of at least 10 years, easing downward pressure on yields at the long end.

"We forecast average inflation of 2 to 3 percent in the next 10 years, so the 10-year government bond yield would be unacceptable if it were to fall much below 3 percent," said an analyst at a European bank in Shanghai.

Economists at the State Information Centre, a key government think tank, on Thursday recommended policies including issuance of 200 billion yuan in long-term construction bonds.

With the prospective influx of such heavy new supplies, some traders think the 10-year bond yield, now at 3.1120 percent, would not drop much below 3.0 percent.

That would bring the one-/10-year spread, now at 49 bps, up to about 80 bps, roughly back at its level early this year.

The long-term charts suggest the bond curve could have even more room to steepen. The one-/10-year spread spent most of last year fluctuating between 100 and 150 basis points. (Editing by Edmund Klamann)