PBOC Bond-Borrowing Plan Fuels Expectation of Action to Raise Yields

The People's Bank of China (PBOC) has implemented measures to cool a bond rally that has resulted in record low yields. This initiative may stabilize the market temporarily, but analysts suggest that a significant shift in investors' preferences for these securities will only occur with restored confidence in the economy [para. 1].

On Monday, the PBOC declared its intent to borrow treasury bonds from primary dealers — financial institutions approved to trade securities with the government — to ensure the stable and healthy operation of the bond market. The underlying expectation is that the PBOC will eventually offload these borrowed bonds into the secondary market to temper the bond-buying surge and elevate government bond yields to a level deemed appropriate by the central bank [para. 2].

Investor interest in China's sovereign bonds has surged due to uncertainties about the country's economic recovery, low bank savings rates, and anticipated further interest-rate cuts. This intense buying activity has significantly increased bond prices while reducing returns, with the yield on the 10-year government bond dropping to a historic low of 2.18% prior to the PBOC’s announcement [para. 3].

The PBOC has issued warnings about the risks of bond buying using borrowed funds, noting that it amplifies market volatility and the potential for significant losses if market conditions reverse. The central bank sees long-term government debt yields as currently too low [para. 4][para. 5]. Analysts suggest that concerns about financial institutions’ exposure to treasury bonds, especially insurers holding large amounts of long-duration bonds, are a probable cause for the PBOC’s decision. Substantial losses for these institutions could pose risks to financial stability similar to the collapse of Silicon Valley Bank (SVB), which suffered from a dramatic drop in asset values due to rising market interest rates [para. 5][para. 6].

The strategies focusing on short-term gains, such as those employed by mutual funds, can compound risks. When bond prices fall, these institutions might rapidly divest, exacerbating price declines [para. 7].

Despite the PBOC's concise statement, it is widely anticipated that the central bank will sell the borrowed bonds in the secondary market to manage the falling government bond yields, at least for a short time [para. 8]. According to analysts from Yuekai Securities Co. Ltd., these sales could ensure yields rebound to a range of 2.5% to 3%, compared to China's potential growth rate of 5%. Current long-term treasury yields have dropped below this range [para. 9].

To have a noticeable impact on interest rates, the PBOC may need to scale its bond sales significantly, potentially involving tens of billions of yuan, according to Huatai Securities Co. Ltd. analysts. Lower-scale sales below 10 billion yuan would likely serve as market guidance rather than having a substantial effect [para. 10].

In the longer term, analysts such as Wei He from Gavekal Dragonomics argue that significant improvements in economic fundamentals are necessary for a more substantial rise in bond yields. Continuing loose liquidity conditions and slowing loan growth point to weak borrowing demand, leading financial institutions to opt for government bonds, thereby keeping yields low. Substantial fiscal and monetary policy support will be needed to reverse the downward trend in long-term bond yields [para. 11][para. 12].