We've Seen This Movie Before

| About: iShares China (FXI)
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In December, China's bond market suffered a veritable meltdown.

The leverage embedded in the market via unregulated bond trading makes a repeat of that episode highly likely.

As it turns out, the contagion channel to equities is the same as it is in the US.

They say everybody needs to sleep.

Well, the steady flow of news out of China and the incessant publication of new analyst notes purporting to synthesize that news makes it well nigh impossible to stay off the desk during the overnight session. Blink, as they say, and you'll miss something.

This week's action has only served to underscore that assessment. The announcement of new capital control measures (temporarily) reversed the prevailing USDCNY trend and simultaneously drove interbank rates in Hong Kong to nosebleed levels.

While the RMB eased against the greenback on Friday (following the largest upside move in history for the offshore yuan), the pressure in offshore money markets did not abate as 3-month HIBOR hit an all-time high and the O/N rate rose to levels that can only be described as absurd (more here).

In short: there's a whole hell of a lot going on. Indeed, there's so much to keep up with that the PBoC seems to be struggling to stay abreast of the action even as they're the ones facilitating it.

One problem for Beijing is that every "fix" tends to create at least one additional problem. This was on full display following the Fed hike in December. The PBoC's efforts to drive up short-term rates by, among other things, extending the tenor of liquidity ops ended up conspiring with a hawkish shift in the FOMC's dot plot to trigger a veritable bond market meltdown. This was exacerbated by counterparty concerns tied to revelations that Sealand Securities (a broker) was balking on its obligation to buy back bonds held on its behalf by third parties. Similar concerns were raised about another entrusted bond deal just days later.

As I've documented exhaustively over the past several months, entrusted bond deals allow Chinese firms to skirt leverage limits on bond trading. Here's how it works (from Bloomberg):

Brokerages and other institutional investors ask counterparties to buy bonds from them when they need to circumvent internal rules on note holdings and leverage, according to Xu Hanfei, a bond analyst at Guotai Junan Securities Co. Or they can simply have third parties buy the notes directly from the market. The practice boosts leverage by effectively giving the financial institutions loans: As brokerages and institutional investors don't carry the bonds on their books, they can use the funds freed up on paper to purchase more bonds, which can then be rolled into more such agreements. "Non-bank financial institutions, which emphasize returns, have more motivation to amplify leverage through entrusted holdings," said Li Liuyang, a market analyst at Bank of Tokyo-Mitsubishi UFJ in Shanghai.

That, in turn, has helped to inflate what can only be described as a bubble:

(Chart: SocGen)

Entrusted bond transactions are unregulated and thus it's nearly impossible to get a read on exactly how big of a risk they pose in terms of the amount of leverage their proliferation has embedded in the market. On Friday, Goldman is out with an estimate based on a Caixin piece and the numbers are not encouraging. To wit (my highlights):

Bond leverage via regulated repo transactions are relatively low - in our earlier work looking at China onshore bond market leverage, we noted that the majority of the bond market leverage was in the form of repo transactions either via the interbank bond market or through the stock exchanges. We have updated that analysis, and estimate that as of the end of 2016, leverage in the interbank bond market was around 1.1x (Exhibit 1) and leverage in the exchange traded bond market was around 1.4x (Exhibit 2).

According to Caixin, the President of China Central Depository & Clearing estimated that bond entrust agreements in the interbank bond market could be as large as RMB 12tn. This is significantly larger than the RMB 4tn of interbank repo outstanding at the end of 2016, and would bring the interbank bond market leverage ratio from 1.1x to 1.6x.

(Charts: Goldman)

Yeah, so that's not good. The logical next question here is this: what would happen should an even steeper bond rout raise new questions about counterparty risk? The answer is self-evident. Heightened concerns about counterparty integrity would reverberate through the multiple layers of leverage embedded in the market sending yields sharply higher.

Now recall how rising stock/bond correlations have undercut US money managers' ability to effectively diversify and hedge. Well wouldn't you know it, the same dynamic is playing out in China. Here's Goldman again (my highlights):

The onshore bond market saw a major correction in late 4Q, with 10Y bond yields rising from 2.7% in end-Oct to 3.4% at present. The increase in short-end rates (7D repo), possibly engineered by the PBoC, was regarded as the key trigger for the selloff given the narrowing spreads between short- and long rates, the leverage employed and duration mismatch in the fixed income market. That said, our economists still expect rates to be largely accommodative throughout the year.

In terms of implications to equities, bond/equity correlation hasn't been conclusive in both the on- and off-shore markets, although the relationships are turning more positive (from extremely negative levels), suggesting that potential further correction in the bond market may put more pressures on equities, everything else equal.

Fundamentally, higher market interest rates may lead to higher corporate funding costs, especially for those which are highly-geared.

In other words, once you tip the first domino, the whole thing falls apart. And all of this as Beijing tries desperately to curtail capital flight.

Bear in mind that the guesstimates (that's what they are) of bond market leverage could be grossly understated.

And for those who would characterize all of the above as fearmongering, remember this: we've already seen this movie. And we know how it ends...

(Chart: SocGen with my additions)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.