Trading Chinese Rates and the Signals That Matter
In Part 1, we covered how China became the most important emerging market on the planet. Its economy is so large that it basically drives the entire EM asset class. We looked at trade links, commodity demand, leverage concerns, the current account surplus disappearing, and the capital account slowly opening up.
Now we get to the really fun part. How do you actually trade Chinese rates? What signals matter? And why should a global macro investor care about Chinese government bonds?
The CNY: An Accelerator for Everything
Let’s start with the currency, because it ties everything together.
The Chinese yuan works like an amplifier for dollar strength against EM currencies. When EUR weakens against USD, USD-CNY tends to move up, and that drags pretty much all of EMFX down with it. The logic is straightforward. A higher USD-CNY signals weaker Chinese demand for commodities. And a weaker CNY forces countries that compete with China in manufacturing to weaken their currencies too. Between commodity exporters and manufacturing competitors, that covers most of EM.
But here’s the thing. It’s not just fundamentals. A lot of it is pure market psychology. When traders see USD-CNY moving higher, they sell everything EM. It’s almost reflexive at this point.
The authors calculate betas of various currencies to the 12-month CNH (the offshore yuan), controlling for EUR-USD moves. The results are pretty intuitive. Commodity currencies like the South African rand, Chilean peso, and Aussie dollar have the highest betas, ranging from 0.5 to above 0.9. Asian currencies like the Korean won are up there too. On the other end, the Mexican peso has almost zero beta to CNH. It’s basically the Swiss franc of EM when it comes to China risk. Mexico actually benefits from US-China trade tensions because supply chains get rerouted there.
The Sun Has Set for the JPY
Here’s a shift that doesn’t get enough attention. The Chinese yuan has already displaced the Japanese yen as the anchor currency for Asia.
The correlation of USD-CNH to USD-Asia is both higher and more stable than the correlation of USD-Asia to the JPY. Part of this is because CNH correlates with EUR, but the trend is clear. The yen used to be the currency that moved all of Asia. Not anymore. If you’re trading Asian FX and you’re not watching CNH as your primary reference point, you’re looking at the wrong screen.
The authors titled this section “The Sun Has Set for the JPY” and it’s hard to argue with them. In the old days, global macro investors obsessed over Japanese government bonds and the yen. That playbook needs updating. China is the new Japan for anyone thinking about the global macro cycle.
How the PBOC Talks to the Market
The PBOC doesn’t communicate like the Fed. There are no press conferences or dot plots. Instead, the PBOC uses the daily CNY fix as its primary signaling tool.
Every morning, the market watches whether the fix comes in stronger or weaker than what the basket of currencies would imply. If the fix deviates from the theoretical level by a large margin for several days in a row, the market reads that as the PBOC saying “we want the currency to move in the other direction.” The authors call this the “countercyclical factor.”
And markets listen. In a normal environment, the game for traders is not to fight the PBOC but to anticipate what the PBOC wants. A 10 basis point error in either direction on the 5-day moving average of the fixing error has been a reliable signal that the CNY is about to change direction.
The one exception was August 2015. The PBOC let the CNY move 1.9% in a single day. That doesn’t sound like much, but it was the largest move in over a decade. The market freaked out. The S&P 500 fell more than 10% in four days. Two-year US rates dropped from 0.97% to 0.78%. The Fed, which had been planning to hike rates at its September meeting, blinked and held. China had literally changed the course of US monetary policy with one currency move.
To stabilize things, China had to burn through roughly $600 billion of FX reserves over the following year and a half. And even that might not have been enough on its own. The DXY happened to turn at roughly the same time. So we still don’t know if China actually stopped the bleeding, or if they just got lucky.
The 12-Month CNH: Your Warning Signal
The authors share a useful trading signal. When the 12-month CNH forward gets more than 5% weaker than CNY spot, that’s historically been a good indicator that the CNY sell-off is getting extreme. The 12-month CNH forward is the main vehicle traders use to express bearish China bets, so when it gets that stretched, positioning is usually crowded.
On the flip side, once the CNY has gotten extreme on the weak side and you want to bet on a reversal, you should express that bet in CNH rather than CNY. The offshore yuan is more volatile and gives you more upside when things snap back.
Chinese Government Bonds: The New JGBs
Now let’s talk about rates, because this is where it gets really interesting for global macro investors.
Chinese monetary policy is not transparent by Western standards. The PBOC doesn’t have a classical inflation target. It doesn’t set rates the way the Fed does. Instead, it uses a mix of tools. Reserve requirement ratio (RRR) cuts for immediate liquidity injections. The medium lending facility (MLF) for 3-month to 1-year funding. The standing lending facility (SLF) for short-term bank liquidity. Reverse repos for daily operations.
The market’s focal point is the 7-day repo rate, because that’s what the PBOC uses for its daily open market operations. It’s also the floating rate for the non-deliverable interest rate swap (ND-IRS) market, which is relatively liquid and widely traded.
Despite all this complexity, the bigger picture is actually pretty simple. PBOC monetary policy has been relatively orthodox. About six months after economic activity starts slowing down, easing begins. That’s not so different from most central banks.
Chinese Yields Lag Their Own Business Cycle
This is where the alpha opportunity lives.
The 5-year ND-IRS swap has a relatively strong correlation with the Li Keqiang index, which is one of the key measures for real economic activity in China. (The Li Keqiang index uses electricity consumption, rail freight, and bank lending as proxies for GDP, since the official GDP numbers are considered unreliable.)
But here’s the kicker. Bond yields have often lagged the activity numbers. That means if you can read the Chinese business cycle correctly, you can position in Chinese rates before the market has fully priced it in. The authors present this as a genuine source of tradable alpha, and the historical charts back them up.
But Chinese Yields Often Lead US Rates
This might be the most important insight in the entire chapter.
Chinese rates and US rates clearly share a common driver. That makes sense. Both economies are plugged into the same global business cycle. But the really useful finding is that Chinese rates often lead US rates, especially at troughs.
In 2009, Chinese rates stopped falling before US rates had clearly bottomed. Chinese rates also led US rates ahead of the taper tantrum in 2013, though with an impractically long lead time of almost a year. And in 2016, Chinese rates led by about six months. For peaks, US rates tend to lead. But Chinese rates peak in a more volatile way, which actually makes it easier to identify when US rates are topping out.
The big rally in Chinese rates that started in March 2018 was a clear signal that the US rates sell-off earlier that year was getting extremely mature. If you were watching Chinese bonds, you had a heads-up.
A Simple Model for Calling Turns
The authors offer a practical trading tool. They regress Chinese rates on US rates using a 52-week rolling window and plot the residuals. It’s intentionally simple, but it works.
When residuals go above 50 basis points, Chinese rates tend to be in a peaking process. When residuals go below negative 50 basis points, Chinese rates tend to be bottoming. It’s not a precise timing tool, but it tells you when Chinese rates are stretched relative to where global factors say they should be. And that’s actionable information.
Index Inclusion: The Big Structural Shift
This part is about flows, and flows matter enormously for a market that foreign investors barely owned.
As of end-2018, foreign ownership of Chinese local bonds was only 2.8%. For Chinese government bonds specifically, it was about 7.9%. Those are tiny numbers for the second-largest bond market in the world.
But the inclusion train was already rolling. In March 2018, Bloomberg agreed to add China to its flagship global aggregate index starting April 2019. Because of the sheer size of the Chinese bond market, the inclusion was being phased in over 20 months. This alone was expected to bring around $150 billion of foreign inflows.
China also entered the JPMorgan GBI-EM index. And the FTSE Russell World Government Bond Index (WGBI) was expected to follow. Combined flows from all three index inclusions were projected to take foreign ownership of CGBs to around 14%.
But here’s what makes it really interesting. Historically, when other EM countries got included in major bond indexes, the actual inflows far exceeded the estimates based strictly on index-tracking funds. Why? Because getting into these indexes requires countries to reform their bond market infrastructure. Those reforms attract non-indexed investors who like the improved liquidity and market access. If that pattern holds for China, foreign ownership could have reached 20% by 2023.
The Double-Edged Sword
The authors are careful to point out that all this foreign capital isn’t free. Yes, inflows help offset the capital outflows from Chinese investors diversifying abroad. And yes, Chinese policymakers actively want foreign capital to come in, partly because the current account surplus is disappearing.
But deeper integration with global markets means shocks travel both ways. Indexed money is usually sticky. But the non-indexed money that follows on the heels of index inclusion is much less loyal. When things go wrong, those investors leave fast.
Given the amount of leverage in the Chinese economy, greater susceptibility to external shocks makes the global system more fragile. The authors essentially say: this is worth watching very carefully.
The Grand Decoupling: Will It Matter?
The US-China relationship has clearly deteriorated. The authors wrote this in 2018-2019, and even then they saw a new Cold War scenario as increasingly plausible. But they argue it wouldn’t diminish China’s impact on EM much. The linkages are economic, not political. They’re driven by the sheer size of China’s economy, which will only keep growing.
The comparison to the US-Soviet Cold War doesn’t hold up. The Soviet Union had almost no economic ties to the West. Exports and imports were each only about 4% of Soviet GDP. China is deeply integrated into the global economy. Unless China literally cuts itself off from the world (which would be an extreme move even in a Cold War scenario), the economic links will persist.
The Dashboard
So what should you watch if you’re trading Chinese assets or anything that China affects (which is basically everything)?
For CNY direction: Watch the daily fixing errors. If the 5-day moving average of the fixing error starts hitting 10 basis points in either direction, the PBOC is signaling it wants a reversal. Don’t fight it.
For positioning extremes: Watch the 12-month CNH forward relative to CNY spot. More than 5% weaker signals that bearish positioning is crowded.
For Chinese rates turns: Watch the residual from a rolling regression of Chinese rates on US rates. Above +50bp means Chinese rates are peaking. Below -50bp means they’re bottoming.
For global rates: Watch Chinese rates as a leading indicator for US rates. Troughs in Chinese yields have consistently led troughs in US yields by several months.
For EM broadly: Watch USD-CNY. It’s the amplifier for dollar strength across all of EM. When USD-CNY is rising, EM suffers. When it stabilizes, EM can breathe.
For structural flows: Track index inclusion timelines and foreign ownership percentages. These are slow-moving but powerful forces.
Bottom Line
The old guard of global macro investors spent their careers watching JGBs and the yen for signals about the world economy. That era is over. Chinese government bonds are the new JGBs. Chinese yields lead US rates at the troughs. The CNY has displaced the JPY as Asia’s anchor currency. And index inclusion is bringing a wall of foreign money into Chinese bonds for the first time.
The irony is that while Chinese bonds are becoming more important for the global financial system, they also make the global financial system more fragile. More foreign ownership of Chinese assets means more channels for shocks to transmit in both directions. It’s a trade-off that policymakers in Beijing and investors around the world will have to manage carefully.
For traders, the message is clear: if Chinese bonds are not on your dashboard, you’re missing one of the most important signals in global macro.
Book Details:
- Title: Trading Fixed Income and FX in Emerging Markets
- Authors: Dirk Willer, Ram Bala Chandran, Kenneth Lam
- Publisher: Wiley
- Year: 2020
- ISBN: 978-1-119-59905-0