Fed puts pressure on Chinese bond bubble

Is the Federal Reserve popping the Chinese bond market bubble? The central bank’s Wednesday announcement that it will raise interest rates more aggressively in 2017 caused bond prices in China to tumble.

On Thursday, Chinese authorities briefly stopped trading in some bond futures in a bid to stem the slide. Chinese 10-year government bond yields (which rise as prices fall) hit a 16-month high of 3.4 percent.

“People woke up to the fact that the bond bubble is too large,” Hao Hong, a researcher at BoCom International, told the Wall Street Journal. “The bond market in China is under severe pressure, across the board.”

The Federal Reserve on Wednesday announced an slight increase in the federal funds rate, a benchmark short-term interest rate. That was expected. But investors were surprised by its announcement that it expects three more rate increases in 2017, sending bond prices around the globe tumbling.

Higher short-term rates in the U.S. tend to lead to higher long-term bond yields, which tend to attract more capital from abroad. As more money flows in from countries like China and Britain, bond prices there fall and yields rise.

The British 10-year government bond yield rose by 0.1 percentage points to 1.352 percent Thursday.

The health of the Chinese financial market matters to New York’s real estate industry because of its importance to the global economy, and because Chinese investors have emerged as important investors and lenders in the local market.

The Chinese government has loosened lending and pumped money into the economy in recent years in order to get accelerate slowing growth. But the measures had the side effect of inflating asset prices to levels many analysts consider unsustainable.

The Fed’s rate announcement also highlights a policy dilemma facing Beijing: should it raise rates and restrict lending in order to stem massive capital outflows? Or should it seek to keep rates low in order to stimulate the economy, at the risk of more capital leaving the country? Either way, additional capital controls could be in store. [WSJ] — Konrad Putzier