19 März 2018, 12:45 GMT
Global financial markets have been a little preoccupied in recent days and weeks. Much of the distraction and volatility have been focused on what the Fed may or may not do over the coming months = monetary policy. More generally, markets (including equity markets) are also focusing on bond yields, credit spreads and currency movements (primarily US Dollar crosses). Not surprisingly, these are all related and profoundly fundamental concepts which help value all kinds of asset classes.
Interestingly, in only the last few years, China has implemented some significant structural foundations to their financial markets, what I call the “ABC” of financial market reform*. Importantly, the connection to current market events is not accidental.
What do you mean by ABC?
A: The development of a bond market that promotes efficient pricing and allocation of capital (we wrote about this last time),
B: Better monetary policy transmission mechanism (see below) and
C: Increased flexibility for the currency to move up and down in a ‘more’ transparent way (for next time).
Specifically for China, “B” ensures the PBOC has better control over the short end of the yield curve, allowing the PBOC to more effectively influence monetary conditions. So, while global bond and risk markets gyrate over the potential actions of the Fed in recent few months, the PBOC has been tightening monetary policy and meanwhile onshore CNY denominated bond yields have been moving higher over the past year or so.
From China’s perspective A, B and C are themselves relatively new concepts and together they have only been around since November 2015. The chart below shows the Shanghai interbank offer rate SHIBOR. We have seen a significant reduction in volatility since the IRC (interest rate corridor) was introduced. More importantly the first real test of this new mechanism was the more recent ‘regulatory tightening’ (see previous comments) which helped reduce volatility at the short end.
Better monetary policy transmission mechanism
At the time of the IRC in 2015 we wrote the following and it still stands today:
“This new monetary policy evolution represents a significant step for the Chinese interest rate market development and is a big positive for investors, allowing for a more transparent and effective mechanism for the transmission of monetary policy. This is especially important as the Chinese economy ... shifts from its current savings-based approach to a consumption-based approach for sustainable long-term growth.”
For now, what does this all mean?
Simply put, China is not a binary trade. Through the cycle:
A: The bond market will help differentiate credit risks better, not perfectly but better.
B: The PBOC can more effectively manage monetary policy and inflation.
C: The currency can act as a ‘better’ natural stabiliser.
More importantly as fixed income investors operating offshore and onshore, we can pick our spots through the cycle from low-to-negatively correlated high-quality government bonds to all kinds of higher risk, higher return corporate debt.
*The irony of the alphabetic analogy for China is not lost on me!
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