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Opinion: “A (nearly) inverted yield curve is worrying China”

by xyonent
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China Yield Curve 23 Jun 2024.png

Bloomberg’s S. Wren“Stock prices are flattening, raising concerns about ‘asset depletion’ and a prolonged recession.”

Whatever the reason, an inverted yield curve has gotten a bad rap. Longer-term bonds typically offer higher interest rates as compensation to lenders for tying up their funds for a longer period. When their yields approach or fall below those of shorter-term bonds, it’s a sign that investors are becoming pessimistic about the outlook for economic growth. In the United States, an inverted yield curve is A reliable predictor of economic downturnsAt least that was the case before the pandemic.

Below is a chart of China’s yield curve today.

sauce: WorldGovernmentBond.com.

There is no inversion for maturities from 1 year to 30 years. However, the 10 year and 3 month spreads are inverting.

Figure 1: China’s year-on-year industrial production growth (black, left scale) and the 10-year 3M spread (blue, right scale). ECRI-defined recession peak-to-trough dates are in grey. Source: OECD, and authors’ calculations.

Chin and Ferrara (2024) We examine the predictability of China’s recessions and industrial production growth. For the former, we obtain no results since recessions have hardly ever occurred during periods when long-term interest rates were available (or during periods that are relevant when financial repression is taken into account). For year-on-year industrial production growth, we obtain the following results:

IP Growth = 0.095 + 1.66 ร— Spread the word

Adjective-R2 = 0.26, NObs = 131, sample = 2007M07-2018M12 (growth through 2019M12). Bold indicates significance at 10% msl using HAC robust standard errors.

Although there is a statistically significant positive correlation between spreads and growth rates, it is not the main explanatory factor, which may not be surprising in the Chinese long-term government bond market. Not very fluidYields on long-term bonds are strongly related to expected future short-term interest rates (i.e., the term structure expectations hypothesis) when long-term bonds are liquid.

Adding additional financial factors, specifically debt service ratio and foreign term spread, increases the Adjusted R .2 This is approximately 0.77.

IP Growth = 0.237 + 0.32 ร— Spread the word – 0.98 ร—dsr+ 1.44 ร— Spread the word*

Adjective-R2 = 0.77, NObs = 131, sample = 2007M07-2018M12 (growth through 2019M12). Bold indicates significance at 10% msl using HAC robust standard errors.

Although the spread is marginally significant, in terms of standardized coefficients, the debt service ratio and foreign term spread are more influential (seven and three times as influential as the term spread, respectively).

Here is the BIS series on private non-financial sector debt service ratios to 2023.

Figure 2: China private non-financial sector debt service ratio, %. Source: Screw.

Look to other indicators for signs of an impending recession, or even a recession.

My previous post on China can be found here.

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