Beijing Flinches 

Doug Nolan


Market drama is reappearing. 

Ten-year Treasury yields traded down to 1.25% in Thursday trading, a notable 35 bps six-week decline to a five-month low. 

German bund yields dropped to negative 0.34%, the low since March. 

French 10-year yields were back down to zero Thursday, before closing the week at 0.05%. 

Swiss yields traded down to negative 0.34%, about 20 bps below their May peak. 

Global equities were under significant pressure. 

At Friday lows, Japan’s Nikkei Index was down 4.7% for the week and near 2021 lows (ending the week 2.9% lower). 

Japan’s TOPIX Bank Index fell 3.5% this week to lows since February (down 16% from March highs). 

South Korea’s Kospi Index dropped almost 3%, before a Friday afternoon rally cut losses for the week to 1.9%. 

Hong Kong’s Hang Seng Index was down more than 5% at Friday lows to the lowest level since December 30th - before ending the week with a 4.1% decline. 

Hong Kong’s China Financials Index dropped another 4.1% this week to 2021 lows, boosting losses since June 1st to 13.5%. 

While Asia suffered the brunt of this week’s sell-off, the great U.S. bull market indicated heightened vulnerability. 

The S&P500 opened Thursday trading down 1.6%. 

Bank stocks dropped 2.8%, pushing the three-session decline to 5.8%. 

Friday’s 3.5% rally cut the week’s losses to 1.2%. 

The broader market has turned highly volatile, indicative of an important change in trend. 

The small cap Russell 2000 was down 4.9% at Thursday lows, only to rally 4.0% to end the week only 1.2% lower. 

July 9 – Bloomberg: “China’s central bank cut the amount of cash most banks must hold in reserve, a move that went further than many economists had expected and suggested growing concerns about the economy’s faltering recovery. 

The People’s Bank of China will reduce the reserve requirement ratio by 0.5 percentage point for most banks… 

That will unleash about 1 trillion yuan ($154bn) of long-term liquidity into the economy and will be effective on July 15, the central bank said.”

Global markets rallied solidly Friday, confirming the view that Chinese developments have become a key market driver. 

The S&P500 rallied 1.1% in Friday trading. 

Germany’s DAX jumped 1.7%, France’s CAC40 rose 2.1%, and Italy’s MIB gained 1.7%. 

European Bank Stocks were down 4% for the week at Thursday lows, before rallying 2.4% Friday. 

Friday’s PBOC bank reserve ratio cut is an intriguing development. 

Beijing has been focused on a cautious stimulus pullback. 

Officials recognize the myriad risks associated with runaway Credit growth and speculative Bubbles in housing and securities markets. 

I’ve doubted this “tightening” process would proceed smoothly. 

Things over recent weeks clearly turned increasingly problematic. 

I have posited that intensifying Chinese Credit stress has been an unappreciated force behind collapsing Treasury and global yields. 

The PBOC was eager to communicate that the reserve adjustment does not signal a change to its “prudent monetary policy.” 

Quite a high-wire balancing act. 

The last thing Beijing wants at this point is to further stoke asset market speculative excess. 

From Reuters: “Part of the liquidity released will help financial institutions to repay maturing medium-term lending facility (MLF) loans, and will also help ease liquidity pressure caused by tax payments, [the PBOC] said.”

Surely, the PBOC’s move goes beyond liquidity management. 

The last reverse cut was in April 2020, in the heart of the pandemic economic downturn. 

The release of Q2 GDP data is due next week. 

While down from Q1’s 18.3% annualized expansion, GDP is expected to have expanded at an 8.0% pace. 

June exports are forecast to have increased 15%, with a huge $44 billion trade surplus. 

The data are not consistent with the narrative that the PBOC was forced to respond to rapidly deteriorating growth dynamics.

Wednesday from China’s State Council: “China will increase the financial support for the real economy, especially the micro, small and medium-sized enterprises. 

To that end, the country will adopt monetary tools such as cuts in the reserve requirement ratio (RRR) for banks at an appropriate time.”

The “appropriate time” arrived expeditiously. 

Beijing’s pivot to a reserve requirement cut had me expecting weak June Credit data. 

Lending, however, was reported Friday much stronger-than-expected. 

Aggregate Financing expanded a blistering $566 billion during June, 27% ahead of estimates. 

This was almost double May’s $296 billion, to the strongest expansion since January’s $800 billion. 

New Loans rose $327 billion, 42% above estimates. 

At $225 billion, Corporate Loan growth was almost double May’s $124 billion, to the strongest expansion since March. 

At $1.292 TN, y-t-d Corporate loan growth is running only 4.6% below comparable 2020 – while 34% ahead of comparable 2019. Corporate Loans have expanded 11.2% over the past year, 25.5% for two years, 39.6% over three and 66.2% over five years.

Consumer Loans expanded $134 billion during June, the biggest increase since March’s $177 billion. 

At $707 billion, y-t-d Consumer Loan growth is running 29% ahead of comparable 2020. 

Consumer Loans have expanded 15.1% over the past year, 31% over two years, 54% over three and 126% over five years.

Government Bonds expanded $116 billion, the briskest growth since September 2020 ($156bn). At $377 billion, y-t-d growth is running 36% below last year’s record level. 

Government Bonds have expanded 16.8% over one year, 36.7% over two and 62.7% over three years.

Aggregate Financing expanded $2.735 TN during the year’s first half. 

And while this was down 15% from the first-half 2020’s Credit onslaught, it is nonetheless an alarming amount of new Credit. 

At $1.969 TN, y-t-d New Loans are actually running 5.5% ahead of comparable 2020 (32% ahead of 2019). 

China’s State Council was certainly not spooked into an unexpected reserve ratio cut due to a precipitous Credit slowdown. 

And there’s no indication of an abrupt change in the economic backdrop. 

China’s Services PMIs were weaker-than-expected, but Manufacturing surveys indicate ongoing strength. 

Producer price pressures remain elevated, with PPI up 8.8% y-o-y in June. 

Analysts (and reporters) struggled to make sense of China’s hasty policy shift: “PBOC’s Surprise Preemptive RRR Cut to Extend Recovery.” “China’s Central Bank Pivots to Easing as Growth Risks Build.” “China signals easier monetary policy, reviving worries about weaker growth.” “China’s Dovish Switch Ignites Fears Over Global Recovery Trade.” “China’s Reserve Ratio Cut Raises Growth Fears, Divides Market.” “PBOC is ‘Confusing’ Markets with Talk of RRR Cut: JPMorgan.”

Is it coincidence that Beijing drops a policy surprise as global bond yields astonish to the downside? 

There has been over recent weeks a marked weakening in Chinese Credit. 

Ominously, Credit stress has been mounting despite exceptionally strong lending and economic growth. 

I believe Beijing’s “pivot” is in response to the recent acceleration in the pace of Credit market deterioration and the associated risk of problematic dislocations.

July 7 – Bloomberg (Rebecca Choong Wilkins): 

“Chinese junk dollar bonds suffered the worst selloff since the pandemic roiled markets last year, as investor concerns about China Evergrande Group drag on the sector. 

Yields on the nation’s riskier notes have been climbing for two weeks to 10.2% through Tuesday… 

Evergrande’s notes have been the worst performers among Chinese dollar debt with its 2025 bond down 5.5 cents so far this week to 60.7 cents. 

There are signs of contagion rippling through China’s riskier debt market as growing concern over the health of Asia’s biggest issuer of junk bonds weighs on the sector. 

Property developers are facing fresh pressures to reduce their debt loads as Beijing looks to curb risk in its financial markets.”

An index of Chinese yield-high dollar bond yields ended the week at 10.43%, up about 70 bps for the week. 

This index traded with a yield of 8.00% as recently as May 26th. 

The yield surge of the past six weeks has been the sharpest since the March 2020 crisis period.

Troubled behemoth developer Evergrande’s four-year bond yields traded above 25% this week. 

Modern Land China’s three-year yields jumped to 18.8% (one-month gain 400bps). 

Developer Sichuan Languang Development Co. is a risk of defaulting on a payment due Sunday.

The marketplace is losing confidence in some of China’s big developers. 

But when it comes to heightened systemic risk, all eyes are for now on the colossal “asset management companies” (AMCs). 

China Huarong CDS jumped 137 bps this week to a one-month high 1,138 bps. 

Fellow AMC China Orient’s CDS increased eight bps to a near record 250 bps, having more than doubled since April. 

July 6 – Bloomberg (Rebecca Choong Wilkins and Ailing Tan): 

“China’s corporate credit market is the world’s biggest, after the U.S. 

It’s also one of the safest. 

The government has backstopped even the most reckless companies, fending off defaults where they were arguably long overdue. 

But those days are now drawing to a close as Beijing forces more accountability on its weakest companies to reduce moral hazard. 

The defaults are coming. In China, the current default rate is around 1%; in more developed markets, it’s closer to 2% to 3%. 

Removing government support in order to close that gap is a delicate process. 

Allow too many firms, or the wrong ones, to fail, and investors’ faith in the overall market will wobble, triggering precisely the crisis that Beijing wants to avoid.” 

Will Beijing stand behind the debt of troubled Haurong and the other AMCs? 

Evergrande and the big developers? 

Local government special purpose vehicles (SPVs)? 

The entire $12 TN Chinese Credit market rests on faith in central government backing. 

And let’s not overlook the Chinese banking system, which will approach $55 TN of assets this year. 

Beijing must begin preparing for history’s greatest bank recapitalization challenge. 

July 9 – Bloomberg (Tian Chen): 

“China’s switch toward monetary easing is making it lucrative for traders to borrow cash to buy sovereign bonds, a strategy disliked by Beijing for its potential to increase financial risks. 

The volume of overnight repurchase contracts surged to 4.1 trillion yuan ($632bn) Thursday, the highest since January, while the cost of such agreements spiked the most in a week on Friday. 

That suggests traders may be using the interbank market to raise funds so they can profit from a rally in government bonds that’s pushed 10-year yields to the lowest in almost a year. 

The so-called carry trade became popular on bets the central bank would loosen policy to buoy growth…”

I have posited that Chinese Credit, with limitless quantities of securities with enticing yields, evolved over this cycle into a hotbed of leveraged “carry trade” speculation. 

Clearly, enormous speculative leverage has accumulated in the Chinese government debt market. 

How much in the domestic bond market? 

And what is the scope of speculative leverage in offshore dollar-denominated Chinese bonds, especially higher-yielding developer and “AMC” bonds? 

Globally attractive yields coupled with implicit Beijing backing, a surefire recipe for one of history’s spectacular Bubbles. 

Has speculative leverage begun to unwind, and does this development help explain the instability taking hold in the Chinese high-yield dollar bond market?

Chinese Credit and speculative excess are integral to the global Bubble – arguably the marginal source of global Credit (while challenging central banks as the marginal source of liquidity). 

And through the lens of the “Core vs. Periphery” analytical framework, instability (de-risking/deleveraging) typically emerges at the “Periphery” and then begins working its way toward the “Core.” 

Risk aversion and deleveraging undermine marketplace liquidity, and warning liquidity and confidence over time encroach upon the “Core.” 

Simplistically, if leveraged speculators get hammered in Chinese bonds, they’ll be forced to slash risk elsewhere. 

It’s somewhat confounding why it took the marketplace so long to lose confidence in Lehman’s short-term liabilities. 

A creeping process suddenly careened at lightning speed. 

I won’t venture a guess as to when the market panics over Beijing’s unworkable Credit system backstop. 

But it seemed clear this week that contagion effects attained important momentum.

July 4 – Bloomberg (Alice Huang): 

“Financial strains among Chinese property developers are hurting the Asian high-yield debt market, where the companies account for a large chunk of bond sales. 

That’s widening a gulf with the region’s investment-grade securities, which have been doing well amid continued stimulus support. 

Yields for Asia’s speculative-grade dollar bonds rose 41 bps in the second quarter…, versus a 5 bps decline for investment-grade debt. 

They’ve increased for six straight weeks, the longest stretch since 2018, driven by a roughly 150 bps increase for Chinese notes.”

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