China Faces Crucial Test In Bond Market As Record Issuance Looms

China’s bond market is bracing for a crucial test this week as the government plans to sell a record 167 billion yuan ($23 billion) of two-year notes amid a deepening selloff in the debt market. The Finance Ministry’s announcement of the largest-ever single auction of two-year government bonds has raised concerns about the potential for weak demand, which could worsen the ongoing market rout. This selloff has already pushed benchmark yields to their highest levels of the year, signaling growing tensions in China’s bond market.

The surge in bond yields this year can be attributed to several factors, including the People’s Bank of China’s (PBOC) reluctance to ease monetary policy, tight liquidity conditions, and a strong rally in Chinese stocks. On Monday, the yield on two-year government bonds reached its highest point since October, having jumped roughly 50 basis points since early January. This upward pressure on yields could deter investors from participating in the bond auction, with many fearing further losses.

The selloff extended into Tuesday, with the yield on the 30-year government bond briefly surpassing 2% for the first time this year. Meanwhile, the yield on the benchmark 10-year debt climbed three basis points to 1.9%. On Friday, alongside the two-year notes auction, China will also offer an additional 30 billion yuan of 30-year bonds, a move similar to previous issuances.

In recent weeks, bond losses have accelerated, driven by weak demand. A notable spike in the one-year yield occurred on February 14, when it gained over nine basis points—the largest increase since 2023—following an auction that saw elevated yields on marginal bids. Last week, another batch of one-year notes was sold at the highest yield since April 2024.

Despite these challenges, Zhaopeng Xing, a senior strategist at Australia & New Zealand Banking Group, cautioned that it is too early to predict a poor outcome for this week’s auction. However, he emphasized that the results will serve as an important indicator of market sentiment.

Market expectations remain that the PBOC will eventually step up liquidity support to address ongoing deflationary pressures and to meet Beijing’s growth targets, especially amid rising trade tensions with the United States. However, the timing of any significant monetary stimulus remains uncertain, given the risks surrounding the yuan.

Since September of last year, the Chinese central bank has refrained from cutting interest rates or reducing banks’ required reserve ratios. It has also halted its purchases of government bonds during the first two months of 2025. Some local fund managers are now predicting that the benchmark debt yield could test 2% if further delays occur in implementing an RRR cut.

Meanwhile, China’s annual supply of new government bonds is set to rise significantly, with a planned issuance of 11.86 trillion yuan this year. This increase comes after the government raised its general budget deficit target to 4% of GDP, marking the highest level in more than 30 years. The mounting debt supply could further strain the bond market, as investors keep a close eye on the government’s fiscal and monetary policies in the months ahead.