China-US yield gap widens to highest level since 2007 after rate cut

China-US yield gap widens to highest level since 2007 after rate cut

China-U.S. Yield Differentials Widest in 16 Years as Speculations Rise on Further Monetary Easing

In a surprising move, the People’s Bank of China (PBOC) cut key policy rates for the second time in three months on Tuesday, signaling an accelerating effort to boost a slowing economy. This unexpected rate cut has led investors to speculate on whether the PBOC will further loosen monetary policy and subsequently put pressure on the yuan. As a result, yield differentials between China and the United States have now reached their widest point in 16 years.

China, in contrast to other global central banks, has taken a unique approach by loosening its monetary policy to support an economy that has shown signs of stalling. On the other hand, countries like the United States have been engaged in tightening cycles as they grapple with higher inflation. This divergent monetary policy path has widened the yield gap between China’s benchmark 10-year government bonds and U.S Treasuries to 164 basis points, the highest since February 2007.

“The significant yield gap, the largest since 2007, could be a key reason why capital remains planted in US dollars and US Treasuries for the time being,” noted David Chao, global market strategist at Asia Pacific at Invesco. He further added, “More broadly, recent economic data releases in China have been disappointing, while those in the U.S. have surprised to the upside.”

The widening yield gap has dampened foreign investor appetite for China’s onshore yuan bonds, as official data shows a decline in overseas investors’ holdings in July. This decline can be attributed to various factors, including disappointing economic data, rising deflation risks, and concerns over default risks at major property developers and missed payments by a private wealth manager.

In the derivatives market, one-year interest rate swaps, which measure investor expectations of future funding costs, fell to 1.84% this week, the lowest since September 2022. This suggests that some market participants are already pricing in the possibility of further rate reductions in China.

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However, despite expectations for further monetary easing, there are concerns about potential capital outflows and the depreciation of the Chinese yuan. The yuan has already depreciated by approximately 5.5% against the dollar since the beginning of the year, making it one of the worst-performing Asian currencies. Eugenia Victorino, head of Asia strategy at SEB, believes that the PBOC will need to take additional measures to manage the pace of yuan depreciation.

This development in the yield differentials reflects the current dynamics between the world’s largest economies. China’s efforts to boost its economy through monetary easing have led to wider yield gaps with the United States. However, the potential risks associated with capital outflows and currency depreciation highlight the challenges China faces in managing its monetary policy effectively.

In conclusion, the recent rate cut by the PBOC and the widening yield differentials between China and the United States have sparked speculation about further monetary easing in China. While this has raised concerns about the depreciation of the Chinese yuan and potential capital outflows, it also highlights the unique approach China has taken to support its economy. As investors continue to monitor these developments, it remains to be seen how China’s central bank will navigate the delicate balance between boosting economic growth and managing the risks associated with monetary policy.

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