Three Quick Insights from the Chinese Equity Melt-Down
July 15, 2015
The US, England, Japan, and some vaguely shifting group of EU nations have shown in the past few years that monetary-policy speaking, they stand apart from other nations. There is no known limit to how accommodating their central banks can be. They can set interest rates at will and not worry about inflation due to a weakening currency. We have yet to see the limit on the quantity of securities they can purchases until the wheels come off. Japan has been doing it for more than a decade.
This leads to insight number one: China is a part of this club. Chinese sovereign bonds operate as a positive carry local currency hedge in RMB. Exhibit A: When the Chinese stock market collapses, Chinese sovereign bonds yields collapse too. These sovereign bonds are the center of gravity precisely because the Chinese authorities can set rates and purchase these bonds as they wish.
Second insight: We witnessed an equity bubble popping, not a credit bubble. Equity bubbles are mild compared to debt bubbles. The Chinese debt bubble doesn’t despite the fact that the growth of China’ debt levels have been epic, the Chinese financial system doesn’t look any more fragile than other financial systems, nor is it ready to blow. Have a look at Chinese LCD financial bond spreads over the sovereign. You saw widening during the sell-off, but nothing like the equity response.
Number three. In terms of relative valuation, Chinese financial bonds are still not cheap. Since 2014, financial bonds have been bid, yet cheap to a model that incorporates equity and bond moves. It took a Chinese equity melt-down to get financial bonds Chinese financial bonds to fair value.