Bearish Swaps Signal Divides SocGen, Deutsche Bank: China Credit

By David Yong & Kim Kyoungwha 

China’s swap market turned cautious on the economy last month for the first time since August and global banks are divided on prospects for growth.

The extra cost of locking in interest rates for five years rather than two shrank to 36 basis points, from 46 on Jan. 31, according to data compiled by Bloomberg. The five-year swap that exchanges fixed payments for the floating seven-day repurchase rate fell seven basis points to 3.69 percent, while the two-year rose three basis points. Societe Generale SA and Bank of America Merrill Lynch said the so-called curve flattening will persist, while Deutsche Bank AG and Standard Chartered Plc forecast renewed steepening. Confidence in the world’s second-biggest economy is being tested as a March 1 report showed manufacturing growth slowed in February, while an Italian election fanned concern Europe’s debt crisis will escalate and the U.S. government is reining in spending. China’s central bank auctioned repurchase agreements on Feb. 19 for the first time since June, withdrawing cash from the banking system to curb inflation. The gap between five- and two-year swap rates narrowed last month in the U.S. and Brazil.

“The latest manufacturing indicator was weaker and this could be the first shift in sentiment against the consensus calling for solid first-half growth,” said Wee-Khoon Chong, a rates strategist in Hong Kong at SocGen. “What’s happening inEurope helped a bit to dent optimism, and see what the U.S. sequestration will bring.”

Manufacturing Cools

Both two- and five-year rates dropped one basis point, or 0.01 percentage point, to 3.33 percent and 3.68 percent respectively as of 11:21 a.m. today in Shangahi.

Chong predicted the spread will narrow by another 30 basis points by the end of April. Deutsche Bank forecast a 20 basis point widening over three months, while Standard Chartered said it expects a reversal of February’s tightening. HSBC Holdings Plc recommends investors bet on steepening should the gap reach 25 basis points. A steepening curve typically indicates expectations for stronger economic growth or quickening inflation.

Chinese manufacturing growth eased in February, with the official Purchasing Managers’ Index dropping to a five-month low of 50.1. A separate index compiled by HSBC and Markit Economics fell to a four-month low of 50.4, still above the 50 level that represents the dividing line between growth and contraction. Chinese leaders will outline plans for the economy at an annual meeting of parliament that begins tomorrow.

PBOC Operations

The central bank’s money-market operations drained a net 5 billion yuan ($803 million) from the financial system last week, official data show. Withdrawals the previous week amounted to a record 910 billion yuan, more than double the previous high in Bloomberg data going back to March 2008, as repo auctions resumed after a weeklong Chinese New Year holiday.

The seven-day repurchase rate, a measure of interbank funding availability, fell 14 basis points today to 4.29 percent in Shanghai, after reaching this year’s high of 4.56 percent on March 1, according to a weighted average compiled by the National Interbank Funding Center. It climbed on each of the last nine working days, the longest run of increases since September 2007.

The flattening yield curve reflects risks that a surge in bank lending in January could fan inflation, complicating efforts to stem a property-market bubble, SocGen’s Chong said. The central bank said on Feb. 6 that China must be alert to changes in price expectations and to imported inflation.

Inflation Risk

Consumer-price gains accelerated to 3 percent in February from 2 percent the previous month, according to the median of 20 estimates in a Bloomberg survey before data due March 9. That would be the biggest increase since May.

Chinese banks handed out 1.07 trillion yuan of loans in January, compared with 738 billion yuan a year earlier, official data show. Aggregate financing, which includes non-bank lending, climbed 914 billion yuan from December to a record 2.54 trillion yuan.

The reintroduction of repo auctions on Feb. 19 didn’t signal a tightening stance by the PBOC, according to strategists at Deutsche Bank, HSBC and Standard Chartered.

“The flattening trend in February may have been induced by similar bias in the U.S. as well as market over-reaction to the PBOC’s repo auction,” said Linan Liu, China rates strategist in Hong Kong at Deutsche Bank. Liu, who initiated a curve- steepening trade in December at about 15 basis points, recommended adding to bets last week as the spread tightened to 31 basis points.

Demand from banks to protect against possible interest-rate increases may also boost longer-dated swaps, contributing to a widening of the gap between five- and two-year contracts, Becky Liu, a Hong Kong-based strategist at Standard Chartered, said in an interview on March 1.

Yuan, Bonds

The existing swap curve is fair relative to HSBC’s own PMI readings, suggesting further prospects for flattening are limited, according to Andre de Silva, the bank’s head of Asia Pacific rates research in Hong Kong. He recommended re-entering steepening bets using offshore non-deliverable swaps should the gap narrow to 25 basis points from 31 last week.

The five-year government bond yield climbed four basis points last month to 3.31 percent, while the yuan weakened 0.04 percent to 6.2213 per dollar, and was little changed at 6.2251 per dollar as of 11:18 a.m. in Shanghai, according to China Foreign Exchange Trade System.

Credit-default swaps protecting Chinese sovereign bonds for five years fell five basis points in February to 64 in New York, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.

Tightening Bias

Signs of policy tightening bias may be under-appreciated, according to Ethan Mou, an interest-rate strategist in Hong Kong at Bank of America. He forecast the gap between China’s five-and two-year swap contracts will narrow a further 15 to 20 basis points by June.

“The government is likely to roll out new measures to control the property markets after rapid increases in prices this year,” Mou said in an interview on March 1. “There is a risk that the economic recovery may not be as strong as the market expects, and the global environment and rates are also pushing for curve flattening.”

To contact the reporters on this story: David Yong in Singapore at dyong@bloomberg.net; Kyoungwha Kim in Singapore at kkim19@bloomberg.net

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