China bill and bond yields

China's bill and bond yields fell across the curve once again on Friday because of expectations that monetary policy would be eased imminently. Traders believe the central bank may cut interest rates and bank reserve ratios as soon as after the close on Friday to bolster the slowing economy, after it let the yield on its three-month bill tumble 81 basis points to 2.0156 percent at Thursday's auction.
"Traders are borrowing funds to buy bonds despite the fact that funding costs are still relatively high. The central bank is expected to ease monetary policy soon," said a trader at a mid-sized Chinese bank. Yi Gang, a deputy governor of the central bank, told a news conference on Friday that the risk of inflation in China had virtually disappeared and the focus of monetary and fiscal policy next year would be to avert the threat of deflation.
UBS predicted in a research note on Friday that China would partly finance its fiscal stimulus package by issuing 1.22 trillion yuan ($178.9 billion) of government bonds in 2009, with over 40 percent of them expected to have tenors of 10-30 years. That would compare with 589.8 billion yuan of government bonds issued so far this year, with 31 percent of the bonds having such long tenors.
But traders think the central bank has ample room to ensure that the market can absorb such large bond issuance, since 2.2 trillion yuan of central bank bills are due to mature in 2009. The indicative five-year government bond yield fell to 2.5140 percent bid on Friday, its lowest in over two years, from 2.5891 percent on Thursday, according to Reuters Reference Rates.
Offshore yuan interest rate swaps fell more sharply, with the five-year non-deliverable IRS down to 1.75 percent bid from the previous day's close of 2.00 percent. Onshore IRS dropped more slowly because they are more sensitive to bond repo rates, which edged up on Friday. But repo rates are widely expected to fall in coming weeks as the central bank eases quantitative policy.
In the repo market, fund companies actively borrowed money to buy bills because of expectations that the central bank might halt all issues of fresh bills as soon as December in order to boost liquidity. This caused the weighted average seven-day repo,which dropped 9 basis points on Thursday, to edge up to 2.7104 percent by midday from the previous close of 2.6909 percent, its lowest level since April.
But traders believe the repo may gradually decline to 2.0-2.2 percent in the next month or so. "The target for the one-year bill yield is about 2.0 percent by the end of the year," said a trader at a mid-sized bank in Shanghai. The one-year central bank bill yield in the secondary market, which has dropped 170 bps in two months, was indicated at 2.3411 percent on Friday, the lowest since at least July 2006, against the previous day's 2.4710 percent.