Yet More Trouble in Bond Land

While everyone else is fixated on the U.S. stock market, I’m watching something more important…credit markets…because that’s where the next big thing is coming from.

Over the last week, another of those issues that no one seems to care about has worsened: the bloodbath in Chinese bonds. Last night, futures plunged back to last week’s lows overnight amid liquidity fears (with short-term lending rates inverting, rising above longer rates) and growing anxiety over China’s unprecedented debt load.

As The Wall Street Journal reports, a gradual tightening of short-term credit by China’s central bank – combined with rumors of liquidity squeezes at brokers – prompted a mini-rout in the country’s $8 trillion-plus bond market last week, forcing authorities to reverse course and inject some $86 billion in short- and medium-term funds. Has the Chinese bond bubble now popped?

This is not a China-specific issue to me. It’s part of the growing pressure on bond markets worldwide in which rates are moving higher against the will of the central banks. It’s more evidence that the extraordinary increase in debt without comparable economic growth is beginning to choke the financial system.

China’s total debt surged to around $27 trillion this year from just $1 trillion in the year 2000. Debt now stands at 260% of gross domestic product, compared with 154% in 2008 at the start of the stimulus program that offset the financial crisis. Debt is continuing to grow at more than twice the pace of the economy. It’s the biggest credit bubble in history, a disaster in the making that will not stop at the Chinese border.

I know what you are thinking, dear reader. You have heard all this before. It didn’t matter then, why should it matter now? Because, dear reader, the market is beginning to show serious signs of stress. A week ago, bond futures fell 2% in minutes. China’s regulator halted trading in bond futures for the first time ever. Then, an auction of Chinese government bonds failed. The failed auction occurred despite the December 2014 adoption of a “primary dealer” system which includes 50 banks. These dealers are required to bid at debt sales, but last Friday some of China’s dealers did not do as mandated. Now, we saw another sharp drop in the 10-year sovereign Chinese bond last night.

Bond traders are clearly worried that short-term rates in China could spike substantially in the next 3 to 6 months. That’s how the last crisis started. Something is up and it isn’t Chinese bonds.

Below is the chart for the trading in the China 10-year over the past week:

Below is the longer term picture. Would you buy this chart?