Germany weighs fiscal stimulus; China govvies are attractive
Recession fears in the market have deepened, but the silver lining is that this has now triggered consideration of more forceful policy responses. Der Spiegel reported on Friday that the German government is looking to relax its zero-deficit rule in the event of a recession. Over the weekend, Fin Min Scholz further raised the possibility of an additional EUR50bn of spending in a crisis, or 0.4% of Eurozone GDP. While stimulus is not imminent , the softening of Germany’s hard budgetary stance helped lift equities and bund yields, bolstering EUR/USD to test 1.11. Given Germany’s negative yields and a debt-to-GDP ratio below 60%, any increased German spending is likely viewed as fiscally sustainable.
The US Commerce Department has extended exemptions for US companies to do some business with a blacklisted Chinese telecoms manufacturer for 90 days. Limited sanctions reprieve offered by the US is one small step to widening the door for a trade deal, but talks are shaping to be a journey of a thousand miles. USD/CNY may stabilize around 7.00-7.10 as trade tensions ebb a little.
Rates: Relatively high China bond yields
We think that China govvies are attractive in this low yield environment. China government bonds have underperformed US Treasuries significantly with the yield premium in the 10Y tenor widening out to 142bps (compared to 59bps at the start of the year). This seems counterintuitive given that Chinese data (retail sales, industrial production and loan growth) have been showing much more signs of stress compared to the US. However, this neglects the point that the People’s Bank of China (PBoC) has been more cautious in disbursing monetary stimulus in the current slowdown compared to previous economic downturns. Notably, the weighted average OMO rate and the 7D repo have been heading sideways as the PBoC keeps liquidity neutral. We still think that targeted easing is in the offing, which could spark more sizable capital gains in govvies.Even if that does not materialise, returns from coupons should still be sufficiently attractive.
The PBoC’s has announcement that new loans should be priced against a revamped benchmark Loan Prime Rate (LPR) from the 20th of August (see here) marks another step towards interest rate liberalization. The LPR provides the financial sector with more leeway to set interest rates (relative to the PBoC’s medium term lending operations rate) in contrast to the existing benchmark 1Y lending rate, which is a much blunter tool used by the PBoC. As banks start to use the LPR, the benchmark 1Y lending rate would lose importance. The PBoC appears concerned that lending rates are diverging (rising) despite stable benchmark rates. If this new mechanism works, we should see the weighted average lending rate fall.
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