On Wednesday, investors predicted that China’s central bank would loosen monetary policy further after a surprise rate cut, even if it puts the yuan under pressure. As a result, yield differentials between China and the US extended to their largest level in 16 years.

On Tuesday, the People’s Bank of China (PBOC) unanticipatedly reduced key policy rates for the second time in three months, providing fresh evidence that the government is stepping up efforts to ease monetary policy in a bid to jump-start a faltering economic recovery. And most markets anticipate that the PBOC will further relax monetary policy.

The PBOC increased its liquidity injection earlier in the session by making the biggest short-term cash offers through seven-day reverse repos in open market operations since February.

China continues to be an anomaly among central banks across the world because it has relaxed monetary policy to support a faltering recovery, whilst others, most notably the United States, have been in cycles of tightening as they combat high inflation.

However, the yield difference between China’s benchmark 10-year government bonds and U.S. Treasuries increased to 164 basis points, the widest since February 2007, as a result of the world’s two largest economies taking different monetary policy routes.

“The significant yield gap, the largest since 2007, could be a key reason why capital remains planted in US dollars and US Treasuries for the time being,” said David Chao, global market strategist at Asia Pacific at Invesco.

“More broadly, recent economic data releases in China have been disappointing, while those in the U.S. have surprised to the upside.”

The growing yield differential decreased foreign interest in China’s onshore yuan bonds; according to the most recent official data, foreign investors’ holdings fell in July.

According to market experts, declining credit growth and rising deflation risks in July called for additional monetary easing measures to stop the decline. Default risks at certain significant real estate developers and missing payments by a private wealth management also reduced trust in China’s financial markets.

One-year interest rate swaps, a measure of investor expectations of future funding costs, fell to 1.84% this week in the futures market, the lowest level since September 2022, indicating that some market players may be pricing in additional rate cuts.

However, the Chinese yuan is under pressure to weaken even more due to concerns associated with capital outflows and expectations for further monetary easing.

The yuan has underperformed other Asian currencies by around 5.5% against the dollar since the year’s beginning.

“The PBOC will need to do more to manage the pace of yuan depreciation,” Eugenia Victorino, head of Asia strategy at SEB, said in a note.

(Adapted from Reuters.com)