China Money: Bond swaps may have peaked as policy normalises
* Market now believes it overshot on tightening expectations
* 2-yr swap spread down 20 bp past month, may fall 30 bp more
* Credit clamp down seen focusing on property sector
* 54 bp rate hikes seen enough to curb inflation expectations
By Karen Yeung
SHANGHAI, Feb 5 - Chinese bond-swap spreads have shrunk dramatically in recent weeks after widening to historical highs, signalling that the rate markets are scaling back excessive expectations for Chinese monetary tightening.
The onshore seven-year bond swap spread <CNYQB7R7Y=> <CN7YTFIX=R> widened 45 bps in two days to a record peak of 103 bps on Jan. 8, surpassing its previous high of 98 bps in June 2007, before trending downward to 80 bps by Thursday.
Some analysts now believe swap spreads, a rough gauge of inflation expectations, are unlikely to rise to fresh peaks because interest rate hikes currently anticipated by the market this year will be enough to manage inflation expectations.
"IRS are ahead of the curve now. The next tightening steps will help to manage inflation expectations, narrowing the spreads further," said Frances Cheung, fixed income analyst at Standard Chartered Bank in Hong Kong.
She expects the two-year swap spread <CNYQB7R2Y=> <CN2YTFIX=R>, which has flattened to 90 bps from a historical high of 110 bps on Jan. 8, will narrow further to 60 bps by the end of the second quarter before stabilising, due in part to expected rate hikes of 27 bps each in the first and second quarters.
A further narrowing of the spread would form a triple-top on the charts, comprising the peaks of Jan. 8 this year and end-October and July last year, giving a classic signal for the end of the uptrend.
NORMALISING POLICY
There were good reasons for the swap spread to balloon last month.
The People's Bank of China unexpectedly let the auction yield on its three-month bills rise as it shifted policy to normalise ultra-loose conditions that had been put in place to fight the global financial crisis.
It also drained funds in its open market operations and raised banks' reserve ratios, to withdraw excessive liquidity and pace a surge in corporate lending at the start of the year.
Rumours of a looming interest rate hike then gathered steam after December consumer price inflation picked up to 1.9 percent. BNP has forecast the consumer price index will rise further to 3 percent this quarter and exceed 5 percent by June or July.
But the PBOC will be cautious in hiking interest rates because it is keen to avoid hobbling growth in the private sector, especially in manufacturing, which remains vulnerable as GDP growth in 2009 relied largely on large infrastructure projects funded by fiscal stimulus spending.
"Unless there is an extremely strong overseas recovery, fuelling interest rate hike expectations, it would be easier for China just to rely on quantitative and administrative measures to reduce domestic inflation pressures," said Shi Lei, analyst at Bank of China.
NO BIG RATE HIKE SEEN
The PBOC may resume withdrawing excess funds from the system in coming months, via stepped-up bill sales, a reserve ratio hike or an increase in bill auction yields, especially if bank lending heats up again.
That could put fresh upward pressure on interest rate swaps and bond yields, which received a respite over the past few weeks as the PBOC paused its drive to mop up excess liquidity for fear of stoking money market volatility in the run-up to the week-long Lunar New Year holiday, which begins on Feb. 14.
Domestic media recently reported that the government's clampdown on credit had also escalated to include strict bank lending quotas and daily reporting on loan volumes.
But the market sees that as intended mainly to avert a property market bubble without curbing other parts of the economy, so there would be little need to raise interest rates significantly.
The euro zone's sovereign debt woes are also expected to make the central bank more cautious about hiking rates.
The latest flattening of the government bond yield curve, after last year's dramatic steepening, seems to confirm that the market is settling on a concoction of at most two rate hikes plus administrative and quantitative tightening as the government's likely formula for achieving official loan and inflation targets.
The spread between the one-year and 10-year government bonds <CN1YTFIX=R> <CN10YTFIX=R> narrowed 21 bps over the past two months to 200 bps on Thursday, suggesting the market was no longer pricing in policy tightening, after a steepening last year to a multiyear peak in anticipation of tightening steps.