China's Bond Market Shift Signals Changing Economic Sentiment

China’s bond market, which was previously burdened with fears of a Japan-like period of deflation and cheap money, is experiencing a notable shift. This week, benchmark yields hit a three-month high, signaling a departure from the pessimistic outlook that had plagued the world’s second-largest economy. The 10-year yield surged above 1.9%, marking a significant five-week rise that has reversed nearly a third of its decline since the start of 2024.

The bond selloff is driven partly by the People’s Bank of China (PBOC)’s unwavering focus on defending the yuan, which has led to a liquidity squeeze and higher borrowing costs in bond and repurchase markets. However, analysts suggest that a more substantial change is occurring — a shift in the prevailing market narrative from fear to cautious optimism.

“The market seems to be shifting away from the narrative of China’s Japanification,” said Larry Hu, chief China economist at Macquarie Group Ltd. He noted that investment trends in China are increasingly focused on growth assets, such as technology stocks, rather than safe haven investments like bonds or dividend stocks. Technology stocks, particularly those of leading companies like Alibaba, have thrived this year.

This change in China’s financial markets mirrors trends in the US, where rising bond yields and falling stock prices are attributed to concerns over the economic impacts of former President Donald Trump’s trade policies.

Central Bank’s Strategy Gaining Ground

The rise in China’s bond yields is seen as a partial victory for the PBOC. The central bank had long clashed with bond bulls, using a combination of verbal interventions, regulatory measures, and bond sales to curb demand. A liquidity squeeze earlier this year gave the PBOC a clearer upper hand.

China’s two-, 10-, and 30-year government bond yields are on track to experience their largest quarterly increase since 2020. A key factor in the bond rout has been the PBOC’s decision to hold off on interest rate cuts since last September, despite widespread expectations for such a move to stimulate the economy.

While the official stance from Chinese policymakers advocates for a “moderately loose” approach, the PBOC has refrained from large-scale bond purchases, tolerated tighter bank liquidity, and maintained its stance on interest rates and reserve requirements. Instead, fiscal policy has taken the lead in stimulating the economy, with additional support from Beijing’s renewed backing of the private sector.

The recent advances in AI, including breakthroughs from companies like DeepSeek, along with successes from Alibaba, have contributed to a shift in sentiment within financial markets.

Deflation Concerns Persist

Despite these signs of recovery, deflation concerns in China remain. The country’s most recent consumer price data showed its first deflationary reading in over a year, driven in part by seasonal factors. Trade tensions with the US, particularly under former President Trump’s tariff policies, continue to put pressure on the Chinese economy. Moreover, President Xi Jinping’s efforts to transition the country’s growth model face significant challenges.

The yield curve in China is also flattening, signaling that investors still have reservations about the economy’s prospects. Edmund Goh, investment director for Asia fixed income at Aberdeen Investments, noted that low inflation and sluggish growth will likely continue to suppress bond yields in the near term.

Shifting Dynamics in China’s Monetary Policy

However, the comparisons to Japan’s prolonged period of ultra-loose monetary policy are now being called into question. Japan’s central bank relied heavily on quantitative easing in an attempt to lift the economy out of stagnation. In contrast, China’s central bank has adopted a more cautious approach, focusing on tightening monetary policy rather than expanding it. Analysts believe that if the PBOC continues to resist interest rate cuts, bond yields could rise further.

“I don’t see any reason to think the 10-year yield couldn’t move above 2%, and it seems more likely that the unwinding of the Japanification trade will continue,” said Adam Wolfe, an emerging markets economist at Absolute Strategy Research.

In summary, China’s bond market is currently undergoing a significant transformation. The fears of Japanification are fading, giving way to a more optimistic outlook for the country’s economic future. While challenges remain, particularly concerning deflation and slower growth, the shift in sentiment reflects broader changes in both domestic policy and global economic dynamics.