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The 'truth' lies in bond markets

During eurozone crisis, when Ireland, Greece and Italian bond yield surpassed 7%, it forced them to ask for bail-outs.  Meanwhile, the bond market made clear where the crisis was heading by pushing the extra spread payable by French bonds compared with German Bunds to a fresh euro-era record; as bond dealers have worked out, bail-outs for weaker eurozone nations will exert extra financial strain on the stronger governments.

In China, its yield curve flattened almost to the point of inversion a month ago, and in recent weeks it has steepened again.  This means the gap between the yields on 10- and two-year bonds thinned almost to nothing – 0.05 percentage points at the lowest point and has now rebounded. Ten-year yields are about 0.8 percentage points higher than two-year yields.

Normally, investors demand a higher yield for longer-term bonds, to compensate for the extra risks of committing for the longer term, primarily inflation. When the yield curve flattens or inverts, it is a signal that investors expect lower interest rates and lower inflation in future. In other words, they expect a recession.

So the record flattening in the Chinese yield curve suggests that investors expect lower interest rates and slower growth. And the recent steepening, as two-year yields fell, implies that local investors think lower interest rates are forthcoming.

Unlike US and Italy where the bond markets are more liquid, China's bond is relatively illiquid.  It can be dangerous to put too much weight on an illiquid market bond's signal.  But according to Chris Watling of London's Longview Economics points out -  the Chinese yield curve also flattened drastically during the crisis of late 2008 – and stimulus was in the offing.

Reference:  Financial Times, 2011-11-11, "Relief at prospect of China's 'soft landing'"