China's Bond Yields: Rising Now, But Deflation Worries Loom

China's bond yields have been on the rise, but economists warn that deflationary pressures could soon pull them back down. The recent increase in bond yields, driven by the People's Bank of China's (PBOC) liquidity drainage and market rotations into stocks, has sent the benchmark 10-year yield to 2%, levels not seen since December. However, the underlying economic conditions suggest that this rise may be short-lived.

The PBOC has been actively draining liquidity from the money market to stabilize the yuan, which has led to an intensified selloff in government bonds. This action, combined with the sudden rise of DeepSeek, has prompted funds to rotate into stocks, further contributing to the selloff in bonds. Edmund Goh, head of China fixed income at Abrdn, cautions that "the market's optimism is ahead of the reality," suggesting that the economy is not yet out of the woods. Consumer sentiment remains near record lows, and credit demand from households and corporates is still anemic. New household loans were just 54.7 billion yuan ($7.5 billion) in the January-February period, marking the lowest level over the same period in the last two decades.

Despite the recent rise in bond yields, the underlying economic conditions suggest that deflationary pressures are likely to keep borrowing costs low. Consumer price inflation in February fell into negative territory for the first time in over a year, while producer price deflation has persisted for over two years. In the first two months of the year, core inflation, which excludes volatile items such as food and energy, is expected to have expanded by just 0.3%, marking the longest deflationary streak since 1993.

The recent rebound in China's government bond yields is not a sign of reflation, as persisting deflationary pressure is expected to keep borrowing costs low. This is validated by the fact that consumer price inflation in February fell into negative territory for the first time in over a year, while producer price deflation has persisted for over two years. In the first two months of the year, core inflation, which excludes volatile items such as food and energy, is expected to have expanded by just 0.3%, marking the longest deflationary streak since 1993.

The rise in bond yields can be compared to global economic indicators. For instance, a rally in U.S. government debt this year, driven by concerns over the impact of tariffs on the slowing economy, has sent yields lower. This has narrowed the gap between U.S. bond yields and those on corresponding Chinese debt. A key source of the weakness in the yuan was the capital outflows to the U.S. where bond yields were higher. Recent market moves that have seen U.S. bond yields decline just as Chinese bond yields have risen have therefore eased the downward pressure on the yuan. Notably, the yield gap, while narrowing to a three-month low, was still substantial.

In summary, while China's bond yields have been rising due to the PBOC's liquidity drainage and market rotations into stocks, deflationary pressures are likely to keep borrowing costs low. This suggests that the recent rise in bond yields may be short-lived, and investors should be prepared for a potential reversal in the coming months.