China’s bond yields are rising but deflation is expected to pull them lower

The recent rebound in China’s government bond yields is not a sign of reflation, economists say, as persisting deflationary pressure is expected to keep borrowing costs low.

An intensified sell-off in China’s government bonds has sent yields rising in recent weeks, as the People’s Bank of China drained liquidity from the money market to stabilize its currency and the sudden rise of DeepSeek prompted funds to rotate into stocks.

The benchmark 10-year yield has gained over 30 basis points from its historic lows in January to hit the psychological level of 2% this week, levels not seen since December.

“The market’s optimism is ahead of the reality,” said Edmund Goh, head of China fixed income at Abrdn, cautioning that there is “no clear signal that the economy is out of the woods yet.”

Consumer sentiment is 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 January-February period, according to data released by PBOC. That marked the lowest level over the same period in the last two decades, according to Larry Hu, chief China economist at Macquarie, citing fading housing market recovery.

Borrowing costs in the broader economy — which typically move in tandem with government bond yields — will likely be “lower for longer,” said Jason Pang, Asia fixed income portfolio manager at JP Morgan asset management.

While expecting monetary policy to remain “accommodative,” the investment bank is “overweight” China’s 10-year government bonds as a “tariff hedge,” expecting yields to trade between 1.65% and 2.0%.

Chinese commercial banks have sought to attract customers with record-low interest loans, heeding to Beijing’s call to spur lending. People have chosen to sock away money as prospects of income growth remain shaky and a prolonged housing market downturn eroded households’ wealth.

Household savings more than doubled from 2018 to about 151 trillion yuan last year even as banks repeatedly cut deposit rates. In the first two months this year, household deposits increased by 6.13 trillion yuan.

National Financial Regulatory Administration last week urged banks to expand issuance of personal consumption loans and set “reasonable” credit limits and interest rates.

Several regional banks across the country have doled out cheap consumption loans with rates as low as 2.58% — a dramatic drop from loan rates above 4.36% in May 2022, according to data from Rong360 Digital Technology Institute.

Loan rates will likely fall further as credit demand remains subdued, said Becky Liu, head of China macro strategy at Standard Chartered Bank, “deflationary pressure is still deepening.”

Liu expects the 10-year government note to yield just 1.4% by the end of this year, as the central bank presses ahead with further monetary easing to bolster growth.

Beijing has made boosting domestic consumption a top policy priority this year as China prepares for a renewed trade war with the U.S. on the back of President Donald Trump’s return to the White House.

The new tariffs Trump imposed on Chinese goods have already weighed on the country’s export growth.

China’s 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 estimated to have risen by just 0.3%, Macquarie’s Hu said, predicting that this would mark the longest deflationary streak since 1993.

To be sure, “low interest rates alone are unlikely to be enough to spark a revival in consumer lending,” said Frederic Neumann, chief Asia economist at HSBC Bank, stressing that achieving such a goal requires “an upturn in confidence” which may only occur gradually.

The majority of Chinese households’ wealth is in property, yet the crisis-hit sector is still struggling to find a floor. New home prices fell 4.8% in February from a year ago, while investment into the real estate development slumped 9.8% on year in the first two months.

A rally in U.S. government debt this year, driven by concerns over the impact tariffs will have on the slowing economy, has sent yields lower. That in turn 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 rise have therefore eased the downward pressure on the yuan.

Notably, the yield gap between China’s 10-year government bond and U.S. 10-year Treasury note, while narrowing to a three-month low, was still substantial at 230 basis points as of Friday, according to LSEG data.

“The risk for a strong RMB is in the near term,” said Ju Wang, head of Greater China FX & rates strategy at BNP Paribas, citing the U.S. Federal Reserve’s plan to further scaling back the bonds it holds on its balance sheet and the rising yield in China’s long-end bonds.

“This could partially ease friction in trade [as] the market will come to realize that China has not only refrained from devaluing the RMB despite 20% tariff, but also allowed some modest appreciation of the yuan,” Wang said.

Chinese offshore yuan has regained some ground against the U.S. dollar in recent weeks, after hitting a 16-month low in January. It was last seen trading at 7.2478 against the greenback. Still, it has weakened over 2% since U.S. President Donald Trump’s election win in November.

The PBOC has kept its benchmark 7-day reverse repo rate unchanged since September, standing at 1.5%, defying expectations that the central bank would lower rates to stimulate the economy. Officials have repeatedly hinted at its plan of further rate easing this year but have not yet followed through.

The Federal Reserve in a closely watched decision Wednesday kept benchmark interest rates steady while indicating reductions are likely later in the year.

“If [China’s] economy continues to slow, or the Fed blinks, the expectation for a rate cut will resurface and the bond yields could fall again,” Macquarie’s Hu said.