This article was written by Rob Waldner, chief strategist and head of the Multi-Sector team for Invesco Fixed Income.
China’s central bank cut key policy interest rates Tuesday to help calm markets after its recent currency devaluation set in motion a cascade of Chinese and global stock market turmoil. The People’s Bank of China (PBoC) cut interest rates by one quarter of a percentage point and lowered the bank reserve requirement (RRR) by one half of a percentage point. The bank also freed up one-year deposit rates, which will allow greater competition for deposits among lenders. Additional cuts were made to lending rates and reserve requirements of some rural banks and leasing companies. We estimate that around 700 billion of renminbi (US $110 billion) in liquidity could be injected into the system by the reserve cuts.
There may be some speculation that these changes to monetary policy may be the start of a form of “quantitative easing” (QE), a stimulative monetary policy we have seen in the US, Europe and Japan to boost growth. However, we at Invesco Fixed Income do not view the PBoC’s latest moves as a broad monetary program along the lines of QE. While QE would be aimed at “getting ahead” of economic slowdown and deflation, we believe the Chinese authorities appear to be merely treading water, injecting sufficient liquidity to replace lost liquidity due to recent currency interventions. In other words, the authorities appear to be responding to recent market movements, but not more. Moreover, Tuesday’s moves appear to have lagged market expectations. A RRR cut appeared to be in the cards in recent weeks, and onshore markets had been expecting an interest rate cut and removal of the deposit rate cap for some time. Without the element of surprise, markets may have already priced in yesterday’s actions, limiting their impact.
Other tools in the policy tool box?
Sharp drops in the Chinese stock market aside, the general economic slowdown underlying market nervousness appears to be concerning Chinese policy makers. Over the weekend, Chinese President Xi discussed a “two bird approach,” for addressing the economy’s current ills. While the meaning of this approach is yet unclear, we believe it may indicate that President Xi believes both monetary and fiscal measures need to be adopted — and on a bolder and grander scale. President Xi’s upcoming visit to the US in mid-September may be a critical opportunity to gain insight into future policy action.
In the meantime, China’s local bond market does not appear to be showing signs of stress. Shorter-term interest rates have trended up due to the withdrawal of liquidity by foreign exchange intervention. However, medium and longer-term interest rates have remained stable, thanks to the large amount of household money shifted from the stock market into the bond market on the heels of stock market volatility. The RRR cut and large injections of liquidity may provide support for Chinese interest rates overall, but we still expect to see volatility in short-term rates, which are most affected by the PBoC’s currency intervention — which we expect to continue.
Market reaction in China and abroad to China’s economic malaise has exceeded policy makers’ expectations, in our view. We believe further interest rate cuts and reductions in the RRR are on the horizon. Larger stimulus measures may also be needed to restore confidence and stem repercussions in China’s currency and the currencies of China’s trading partners. A glimmer of hope shone through in Tuesday’s trading as prices picked up on bonds of Chinese property companies. However, we will be watching for signs of health in the real economy as a test of policy success, signs that still appear elusive.
We remain cautious on emerging markets, particularly Asian currencies and credits. The position-driven movements in global markets since the renminbi devaluation two weeks ago have created some attractive opportunities in some markets where the fundamentals are positive but corrections have driven spreads higher. Invesco Fixed Income favors domestically focused US investment grade and high yield securities. Spreads are attractive and the fundamentals of the US economy remain solid, in our view.
About risk
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.