Pork Shock – What Next For Chinese Bonds?

Foreign investors purchased about USD65bn in Chinese onshore fixed income YTD, a record high. Foreigners now own about USD300bn – or about 2.4% – of the outstanding stock of the onshore bond market.

Most foreign portfolio managers that I speak to expect even larger inflows next year. Foreign central banks were the early investors in onshore Chinese bonds, but foreign asset managers have been the main marginal buyers in 2019. A recently published survey of institutional investors commissioned by Invesco (here, page 18) suggests that there is overwhelming interest in increasing China exposure. Indeed, from an asset allocation point of view, the Chinese bond market is structurally under-owned by foreign investors.

Offshore real money investors frequently tell me that, when compared against core CPI (Chart 1), Chinese bond yields screen very attractive relative to developed markets. Together with the longer-term arguments about demographics and industrial over-capacity in China, and alongside negative yields in Europe and Japan, I can understand why these investors are so keen to increase their China allocations.

Chart 1: Chinese Bond Yields Seem High Relative to Inflation

But despite their enthusiasm about inflows, I believe the near-term prospects for the Chinese bond market raise questions. 10Y CGB yields have risen about 25bps since August lows, and I think a further 25bps rise is likely before a (possible!) cyclical buying opportunity might materialize.

4 reasons for my caution are as follows

1. Foreign investors don’t matter. Unlike other EM bond markets, foreign investors are not the marginal price driver in China. They are simply too small. This year’s ‘record’ inflows took down less than 10% of net supply. Even if inflows doubled next year, they would still be too small to determine bond prices in the near term.

2. Core inflation could rise. It may be a mistake to form your view on duration by taking the current low level of core CPI and negative PPI, since current levels may be at cycle lows (chart 2). The more important issue is when, and by how much, will pork prices spill over to core? Don’t underestimate the risks here. The African Swine Flu (ASF) has already cut production by at least one third. And it has nearly tripled wholesale pork prices. There is no vaccine yet – so the only way to stop the disease is to destroy infected herds. Production is unlikely to recover soon, and imports will at best cushion the impact. So far, the market has taken the inflation risk in stride, but I suspect headline might spike over 5% at some point next year. And if core is also showing signs of life at that time, the Chinese bond market could have a really, really bad day.

Chart 2: Core Inflation May Be at Lows

3. PBoC may not help. From a monetary policy perspective, this is a classic ‘oil shock’ kind of problem. Should PBoC react or ignore? I think their reaction depends on the lengthof supply disruption. If the supply shock is temporary, they can ignore it. Unfortunately, the ASF pandemic looks like a much more persistent, multi-year supply shock – and if mishandled, could lead to a wage-price spiral. The PBoC will probably maintain its easing policy stance, but as in recent months, fiscal policy will do the heavy lifting on stimulus and monetary policy will deliver low-profile facilities such as MLF and targeted measures to prevent a sharp rise in market interest rates rather than proactive measures to engineer a fall. Repo funding will probably remain in the 2.5-3% range, though risk is on the top side in my view.

4. Cyclical turn. While PPI inflation is negative now, note that base effects will help push it back above zero in Q4. Moreover, industrial sectors such as steel have destocked for a while, so inventories are lean. Some of the PMI data hints at a bottoming of the economy, and while the recovery in 2020 is likely to be feeble, there may be a lot of initial optimism if the US/China trade deal results in substantial tariff relief. This would help the RMB but could hurt duration.

Mirza is a macro strategist, specialising in Asian FX and fixed income markets. Mirza is currently working as a desk analyst at Morgan Stanley, prior to which he worked in macro strategy roles at BNP Paribas and Deutsche Bank

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