INTEREST RATE WEEKLY
Background:
Risk asset prices have declined in September, and the US dollar has started to rebound,indicating weakening global risk appetite. The overall reason is that markets have had highexpectations for stimulus policies and economic recovery after massive liquidity injectionsworldwide that have pushed up risk appetite and risk asset prices. Therefore, with theresurgence of COVID-19 cases in Europe and the US, as well as marginal tightening ofglobal liquidity and fiscal policies, risk appetite and overvalued risk asset prices havestarted to decline. In addition, as the US presidential election heats up, uncertaintyabounds, and we expect risk assets to come under pressure.
China’s bond market is finally turning bullish after continuous bearish performance. Supplypressure for interest rate bonds has started to ease. Interbank deposit rates stop risingafter the PBoC injects liquidity through medium-term lending facility (MLF) operations. Weexpect more overseas funds to flow into China’s bonds with the inclusion of China’streasury bonds in the FTSE World Government Bond Index (WGBI). Industrial productprices will also drop from highs, which we argue will curb PPI and production, leading todecline in PMI and value added of industry (VAI). Bond supply and demand as well asfundamentals will be conducive to China’s bonds, in our opinion. However, we feelinvestors in general are still taking a cautious stance on China’s bond market as they holdvarious opinions towards inflation and the economy in 2021. Looking ahead, will tradingopportunities arise in bond market in 4Q20?
Key takeaways
Our latest survey in September1 shows risk appetite has weakened as global risk assetprices continue to decline. In contrast to our previous survey, the respondents this time are more worried about global risks such as resurgence of COVID-19 cases, the US presidentialelection, and geopolitical tensions in certain parts of the world. With the large rebound inCOVID-19 cases in Europe, investors are expecting the global pandemic to peak in 1H21.
Concerns on the ongoing COVID-19 pandemic also represent one of the major factors thatled to weakening risk appetite in 4Q20. The respondents are pessimistic about globalmonetary policy and fiscal policy, and concerns remain over the tightening liquidity by thePBoC. With tightening of property regulations, limited infrastructure investment in 4Q20,and the tightening of broad money supply, or “M2”, markets expect economic growthmomentum to slow, leading to decline in long-term interest rate and average yields onlong-term interest rate bonds.
Although bond markets have turned upbeat as risk appetite weakens, investors are stilltaking a cautious approach towards China’s bond market. After the bumpy ride since thestart of this year, bond investors are starting to worry that even a slight hint of bearishelement could possibly result in a tumbling bond market.
However, we think investors are overreacting a bit as we see the previous bearish elementsare improving. On the one hand, supply and demand of interest rate bonds are morebalanced amid slowing bond supply and ease of pressure on banks’ liability side. On theother hand, we expect to see marginal tightening of M2 amid tightening regulations onreal estate and trusts. The MCI monetary condition index is likely to rise amid slowingcurrency supply, rising interest rate, and stronger RMB, which we argue could curb theeconomic growth momentum, which is bullish for the bond market in terms offundamentals. Moreover, yields on China’s interest rate bonds have already climbed back,if not exceeded the previous high levels earlier this year. Therefore, prices of China’sinterest rate bonds are more appealing compared with overseas treasury bonds and othermajor assets.
Since China has been a pursuing stable monetary policy, we do not expect a tighteningmonetary policy in the near future, and may even see more liquidity injections instead.
Therefore, investors could consider increasing exposure to China’s bonds and awaitopportunities, which may arise in 4Q20 or even in 2021, when governments gradually stopimplementing stimulus policies, which could curb the economy from growing, leading tofurther decline in interest rates, in our opinion.
Most of the respondents believe China’s economic growth momentum will continue orslightly slow in the forthcoming months. Investors are less optimistic that infrastructurecan boost the economy compared with early this year. They argue that infrastructure couldnot boost demand as much as when the economy recovers, not to mention the suspensionof construction when the weather cools. Therefore, infrastructure growth is not likely torise, but will stay flat in 4Q20, in our opinion.
Surveyed participants are optimistic on the real estate sector, despite high frequency datain the real estate sector weakening, coupled with declining prices of ferrous metals,indicating weak expectations on real estate infrastructure in future. We expect the realestate sector to weaken in the next 1–2 months. The tightening M2 and declining exportscould also slow the economic growth momentum, not to mention the global risksamassing in 4Q20, which could result in declining risk appetite, leading to rising volatility ofrisk assets. In addition, with the resurgence in COVID-19 cases, anemic consumerconfidence, and rising pork supply in China, the respondents are less concerned aboutinflation.
As for overseas monetary policy, the respondents are pessimistic about further stimuluspolicy introduced by the Fed and do not have high expectations of the Fed introducingyield curve control (YCC) policy by the end of this year. About 70% of the respondentsbelieve the Fed will not introduce YCC by the end of this year, including 31% who insist thatthe Fed will not do that by the end of 2021 either; the other 39% argue that the policy ismerely a concept. Only 9% of the respondents believe that the Fed will introduce the YCC by the end of this year.
As for the PBoC’s policy, as many as 77% of the respondents believe there will be nofurther stimulus policy. About 7% of the respondents even argue the PBoC could tightenliquidity. We believe that overall market is overly pessimistic on China’s monetary policy,and trading opportunities will likely arise if possible policy easing is implemented whichcould easily beat market consensus in the future. As for 7-day repo rate, most of therespondents argue the rate will fluctuate within the current range. About 45% expect the7-day report rate to fluctuate within 2.0–2.25%, and about 41% expect the rate to fallwithin 2.25–2.50%, higher compared with our previous survey. With the injections ofgovernment fiscal deposits as year-end approaches, we expect some opportunities to ariseas liquidity improves.
As for US dollar currency index (DXY), most surveyed participants believe the DXY rally willlikely lose steam. They think the DXY will weaken again when it rises to about 95 and willfluctuate within 93–97 in the next several months. When answering “what are possiblefactors that could result in the plummet of China’s bond yields in the next severalmonths?”, 59% of the respondents chose the escalation of China-US relations, followed by48% who chose marginal tightening of monetary policy, slowing total social financing (TSF),and tightening regulations on real estate, which we argue could curb the economy andresult in the declining of long-term interest rates. Fewer respondents chose “funds willdiverge from the equity to the bond market amid easing monetary policy and pricecorrection in the equity market” compared with the previous survey.
The respondents believe US treasury bond yields could fall within an average of 0.5–0.7%in the coming 3 months, as they did in the previous survey. About 73% of respondentsbelieve China’s treasury bond yields could stay at the current level or slightly fluctuate byless than 10bp. About 61% argue yields on China Development Bank (CDB) bonds will stayat the current level or slightly fluctuate by less than 10bp.
We observed that the respondents this time are more optimistic (they believe there’s moreroom to fall) towards the yields on China’s treasury bonds in the coming 3 months, ascurrent yields are already 10bp higher compared with previous survey, and the previousbearish elements are now turning better. The respondents are much more optimistictowards CDB bonds, as 26% believe the CDB bond yields will drop by over 20bp comparedto only 12% who argue China’s treasury bond yields will drop by this much, which webelieve is due to CDB bond supply pressure being less intense compared with China’streasury bonds which mainly invest through on-balance-sheet business.
The respondents are more pessimistic on credit spread as more believe credit spread ofhigh-grade credit bonds and low-grade credit bonds will widen, the former in particular. Itshows that markets have growing concerns over the lower risk premiums for credit bondsas credit spread is at a historic low and there is no clear sign that interest rate bond yieldswill plummet. As for credit risk, over 60% of respondents believe number of new bonddefaulters will not surge in 4Q20, and about one-third of the respondents argue there willbe more credit events such as extension of bond repayment. They argue the unexpecteddefault of SOE bond issuers with mounting liquidity pressures will likely affect the markets.
About 30% of respondents believe the number of new defaulters in 4Q20 will remain at alow level and will not affect the markets.
As for perpetual bonds, nearly 70% of the respondents believe supply and demand ofperpetual bonds will deteriorate, leading to widening spread, including 30% ofrespondents who will consider increasing exposure to perpetual bonds as the spreadwidens. Nearly one-third of the respondents will wait for opportunities to increaseexposure when monetary policy becomes clear and the spread stabilizes. As for convertiblebonds, most investors do not expect convertible bonds to slide. Therefore, investors couldconsider increasing exposure in the short term, in our view.
In terms of asset allocation and investment strategies, 29% of the respondents chose toreduce the duration, followed by “relative value strategy”, “swing trading” and “to extendthe duration”. The respondents are more upbeat towards the bond market compared withprevious survey, but are still taking a cautious approach. After the bumpy ride since thestart of this year, as many as 47% of the respondents are starting to worry that even aslight hint of bearish element could possibly result in a tumbling bond market. However,we think investors are overreacting a bit. We see that the previous bearish elements arenow turning better. Therefore, we do not expect bond yields to continue to rise.
The respondents are apparently worried about potential default risks compared with theprevious survey, which we argue has something to do with the recent tightening of realestate regulations and some negative news about certain property developers.
In terms of wealth management funds, fewer investors allocate equity or equity funds thanin the previous survey, whereas more of the respondents chose to allocate money fund orbond fund, indicating weakening risk appetite among investors. As for major assets withthe most growth potential in the coming 3 months, most of the respondents choseequities, accounting for 41%, much less compared with the previous survey, followed byinterest rate bonds, accounting for 28%. We see that the respondents in general tend tochoose risk haven assets and try to avoid risk assets, the opposite from the previoussurvey. Looking ahead, we do not expect risk appetite to suddenly change within the shortterm, unless there is another round of massive global monetary and fiscal stimulus. We donot think it is likely to happen, and the hands of the asset class clock will still turn toChina’s bonds, in our opinion.
