China Money: Bill/IRS spreads to widen further

The spread between Chinese bill yields and interest rate swaps is at its widest in years. But it's set to get even wider, thanks to the way in which China is reacting to high inflation and the prospect of slower growth.

The central bank seems keen to prevent any major fall in bill yields, and may conceivably guide them a little higher in coming weeks. But it also appears eager to keep down banks' cost of funding, leaving the way clear for a further slide in IRS rates.

"The central bank may engineer a small rise in bill yields as there is still room for one interest rate hike. But IRS rates have room to drop," says Ye Yuzhang, trader at Industrial Bank.

The one-year central bank bill yield has stayed remarkably flat since mid-November, moving in a range of just 6 basis points. It's indicated bid on Friday was 4.0860 percent.

Its stability is largely due to the way in which the central bank has been conducting its one-year bill auctions, keeping the auction yield at 4.0583 percent for 12 sales in a row.

The central bank seems to be doing this for two reasons. Late last year it had trouble draining money in its open market operations, but by supporting the auction yield at a relatively high level, it has become able to attract enough demand for one-year bills to drain funds comfortably.

The other reason appears to be the central bank's efforts to curb growth in banks' corporate lending. A one-year bill yield at 4.0583 percent is high enough to encourage banks to put much of their money into bills, rather than lending it out to companies.

Meanwhile, the onshore one-year interest rate swap rate is down 70 bps since mid-November because of a shift in central bank policy towards using appreciation of the yuan to fight inflation, and as plunging U.S. interest rates have reduced room for China to raise its official rates.

That has widened the one-year spread between bills and onshore IRS, from a range of about 0-40 bps for most of last year to 95-110 bps since February -- the widest in at least two years.

LOOSE LIQUIDITY

Traders are now talking of another expansion of the spread, by at least 15 or 20 bps in the next few months.

The central bank is showing no sign of letting the one-year bill yield fall at auction, limiting room for the secondary market yield to fall to as little as a few bps, traders say.

With consumer price inflation at an 11-year high of 8.7 percent in February, the market still sees a reasonable chance for a 27 bp hike in official interest rates by mid-year. That could actually push longer-term bill yields up slightly.

At the same time, however, traders say the central bank has become more generous with liquidity since the start of this year, in order to prevent small banks and companies from getting into trouble as the U.S. economic slowdown threatens China.

The result is seen in the seven-day bond repurchase rate , the key measure of short-term liquidity and a major influence on IRS. After rising steadily from mid-2007 through January, the repo rate's 100-day average has begun trending down. It has slid to 3.11 percent from a peak of 3.54 percent in early February.

Late last year, the central bank seemed to be creating an unofficial floor of 2.70 percent for the seven-day repo. But in recent weeks, the rate has stayed below that level and the bank has halted its seven-day repo operations, apparently to make it easier for small banks to obtain funding in the repo market.

Since most Chinese IRS deals use the seven-day repo for the floating leg, IRS rates are very responsive to repo rates, and traders think the repo downtrend will soon push IRS down further.
"Ample liquidity is keeping repo rates soft, and this will eventually cause another step down in IRS," says a trader at a major Chinese bank in Shanghai.

Two other factors could add to downward pressure on IRS. One is reform of the system for initial public offers of equity.

Big IPOs have triggered vicious money market funding squeezes over the past 18 months as applicants to the offers have been required to deposit money with clearing banks. The squeezes have caused repo rates to spike, pushing up IRS.

One innovation announced this year is an electronic system which would channel institutional subscriptions to a wider range of clearing banks, easing any squeeze. Other reforms under consideration include a prohibition on investors subscribing to both the retail and institutional tranches of an IPO.

Standard Chartered Bank said falling repo rates could also encourage banks not to hedge bond purchases in the IRS market -- removing another source of upward pressure on IRS.

"Expectations for repo to stay soft could mean that investors may simply go long bonds, funding themselves via repo, without going into any IRS trade for now," it said in a research note.