China bonds as an inflation hedge | Manulife Investment Management

There’s a belief that U.S. inflationary pressures can be negative for the Chinese yuan (CNY). This is because, historically, U.S. inflationary pressures have led the U.S. Federal Reserve (Fed) to tighten monetary policy, causing U.S. Treasury yields to move higher as investors become concerned about inflation. Consequently, the yield advantage of China’s interest rates over U.S. Treasury yields would narrow, as the latter rise while the former remains stable. The yield advantage that China bonds offer has been one of the key drivers for global investors to invest in China bonds, which has helped the CNY to appreciate. Therefore, if the yield differential declines, investors could pull funds away from China bonds, leading to a weaker CNY against the U.S. dollar (USD).

Contrary to the above expectations, we’ve noticed that U.S. inflationary pressures don’t necessarily lead to an underperformance in the CNY. In fact, historical data shows that the CNY had tracked U.S. inflationary pressures quite closely, as indicated by the U.S. five-year break-even rate, which is a gauge of the market’s expectations for U.S. inflation. Meanwhile, the CNY had also tracked the official annual U.S. Consumer Price Index on an ex-post basis. This tells us that as U.S. inflation ticked higher, the CNY appreciated against the USD (during these periods).

CNY appreciated against USD as U.S. inflationary expectations moved higher

Chart mapping the U.S. five-year break-even rate against the U.S. dollar/Chinese renminbi pair during the five-year period ending on November 30, 2021. The chart shows that there’s a strong direct correlation between the two sets of indicators.

Source: Bloomberg, data as of November 30, 2021.

CNY appreciated against USD as U.S. inflation moved higher

Chart mapping the U.S. Consumer Price Index against the U.S. dollar/renminbi currency pair in the last five years, ending October 31, 2021. The chart shows that there’s a discernible direct correlation between the two indicators.

Source: Bloomberg, data as of October 31, 2021. CPI refers to the Consumer Price Index.

Thinking this through, we believe it could make sense for China onshore bonds (and the CNY) to be a positive-yielding hedge against inflationary pressures due to the following reasons:

1 Strong U.S. inflation reflects an overall expansionary stance in U.S. economic policy

In response to the global pandemic, the Fed has been dovish and is still expanding its balance sheet well into the first quarter of 2022 despite tapering. Even with the market pricing in +0.75% in rate hikes for 2022, negative U.S. real rates will prevail with CPI running above 5.00%.

2 U.S. inflation may not be transitory

We believe higher U.S. inflation may not be transitory in nature, reflecting only temporary supply shocks. Rather, higher inflation is likely a consequence of stronger U.S. demand and goods consumption. Higher consumption and imports in the United States are positive contributors to China’s trade surplus, which is also positive for the CNY.

3 U.S. inflation is outpacing that of China

With U.S. inflation currently outpacing China inflation, the value of the CNY (in real terms) is likely to be closer to fair value compared with the USD, which is more likely to be overvalued due to its higher inflation based on the real effective exchange rate (REER). The REER is a measure of a currency’s value against those of its major trading partners after adjusting for inflation.

4 The market is in a risk-on mode

A market environment with higher break-even rates and low-to-negative real yields is generally associated with a risk-on mode (i.e., global investors are more likely to allocate away from U.S. Treasuries to higher-risk asset classes in this environment). Hence, on this basis, a greater allocation to CNY assets can be expected.

Five-year returns of China bonds (unhedged) vs. U.S. Treasury inflation-linked bonds

Chart comparing the returns of the following indexes in the last 10 years (ending November 30, 2021): The Bloomberg U.S. Treasury Total Return Index, the Bloomberg U.S. Treasury Inflation-Linked Bond Index, and the Bloomberg Global Aggregate China Total Return Index (Unhedged, in U.S. dollars). The chart shows that the Bloomberg Global Aggregate China Total Return Index returned the most of the three indexes during the period, followed by the Bloomberg U.S. Treasury Inflation Linked Index.

Bloomberg, data as of November 30, 2021.

As inflation has ramped up in the last 12 months, we’ve seen U.S. Treasury inflation-linked bonds outperform U.S. Treasuries over this time. Similarly, China bonds (unhedged) have performed strongly and kept pace with the performance of U.S. Treasury Inflation-linked bonds over the same period, giving support to our thesis that China bonds can provide investors with a hedge against U.S. inflation.

Conclusion

We’ve highlighted some of our key observations and explained why we think China government bonds and the CNY have the potential to act as hedges against U.S. inflation. China bonds are already an attractive asset class, given their higher nominal and real yields and diversification benefits (due to a lower correlation with other assets). However, the potential for China bonds to be a positive-yielding asset that also hedges against rising global inflation further enhances their appeal. We believe there’s now an even stronger case for considering China bonds as a key part of global investors’ portfolios.

Important disclosures

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