China Bonds Lead Globally with 3.5% Return Amid Low Inflation

Key Takeaway

• China's government bonds have outperformed globally with a 3.5% return, driven by low inflation and potential PBOC rate cuts.
• U.S. 10-year Treasury auction saw strong demand, signaling investor expectations for lower inflation and a dovish Fed stance.
• Bond market remains highly sensitive to macroeconomic data, with yields more volatile than equities year-to-date.

China Bonds Outperform

China's government bonds have significantly outperformed their global peers this year, with a return of 3.5% based on Bloomberg data. This performance is well ahead of the next best performer, South Africa, which has seen a 1.8% advance. The strong showing of Chinese bonds is expected to continue, bolstered by the latest inflation data.

Bloomberg Economics (BE) anticipates that China's May price data will reveal continued low inflation, similar to April's levels. Consumer price gains are likely to stagnate, while factory-gate prices are expected to remain in deflation for the 20th consecutive month. This economic sluggishness is putting pressure on the People's Bank of China (PBOC) to ease monetary policy. BE suggests that a window is opening for the PBOC to trim its one-year rate this month, especially since the European Central Bank (ECB) and the Bank of Canada have already eased their policies.

The PBOC has expressed discomfort with the decades-low yields that have been weighing on the yuan. There is speculation that the central bank might step into the market to sell bonds if the bond rally continues. A newspaper backed by the PBOC has indicated that the central bank could add to its policy toolbox by buying and selling government securities, though market watchers are still debating how this would work in practice.

U.S. Treasury Auction Signals Investor Sentiment

In the U.S., the strong reception to the recent 10-year Treasury sale indicates that investors are preparing for inflation to resume its downward trend. The $39 billion reopened 10-year auction saw the strongest demand since just before the start of the rate hike cycle in March 2022. This suggests that investors are banking on a dovish outcome from the Federal Reserve's upcoming meeting.

The Bloomberg consensus and the Cleveland Fed’s Inflation Nowcast project May monthly core inflation to rise by 0.3%. However, there is a possibility that the figure could be rounded up from a "weak" 0.25% to 0.3%, or it could slow to a 0.2% monthly pace. Either scenario would mean two slower inflation prints in April and May, following 0.4% readings in January, February, and March. Such figures would likely soothe Federal Reserve officials.

Edward Bolingbroke of Bloomberg News notes that traders are rapidly unwinding bets for a bond rally, indicating a less optimistic outlook. The bond market remains short, which can lead to a squeeze, and risk linked to EU politics is driving demand for the safety of U.S. government debt. However, a "strong" 0.3% inflation print could result in increased yields and a neutral-sounding Fed that keeps shorts in place.

Bond Market Volatility

The bond market continues to be more reactive to macroeconomic data than equities, with yields remaining range-bound overall. According to Tanvir Sandhu, Bloomberg Intelligence's chief global derivatives strategist, rates are acting as a shock absorber, while the stock market is dominated by the secular theme of AI and high dispersion, contributing to lower index volatility.

Year-to-date, the average move of two-year yields on CPI data-release days is 13.4 basis points, about 3 basis points higher than in 2023 and close to the 2022 average. In contrast, the S&P 500's average realized move is 0.93% year-to-date, much lower than 2022's 1.93%. This indicates that the bond market remains highly sensitive to key macroeconomic data, while the stock market experiences lower volatility.