Yields on Chinese government bonds have risen to their highest level in nearly six years, as a confluence of factors makes investors more demanding

China Bond Yields Soar

Inflation Worries, Growth Outlook, Central Bank Moves Make Investors More Demanding

SHEN HONG

Updated Oct. 24, 2013 6:10 a.m. ET

SHANGHAI—Yields on Chinese government bonds have risen to their highest level in nearly six years, as a confluence of factors makes investors more demanding, analysts say. The yield on the benchmark 10-year bond hit 4.20% Thursday, the highest since it reached 4.60% in November 2007. “Rising inflationary pressures, a rebound in economic growth and the central bank’s shift toward a slightly more hawkish monetary policy have led to tighter liquidity conditions,” said Chen Long, an analyst at Bank of Dongguan. “These have made bonds less attractive to investors.”On inflation, prices in September were up 3.1% from a year earlier, accelerating from August’s 2.6% pace.

On growth, there is increasing optimism about the staying power of a nascent economic recovery that began in July. China’s third-quarter gross domestic product was up 7.8% from a year earlier, improving on the second quarter’s 7.5% and the first quarter’s 7.7%.

In the latest sign, the preliminary HSBC China Manufacturing Purchasing Managers Index—a popular gauge of manufacturing activity—came in at 50.9 in October, compared with a final reading of 50.2 in September, HSBC Holdings PLC said Thursday. That is a seven-month high. A figure above 50 indicates expansion from the previous month, while a reading below 50 indicates contraction.

And then there is the People’s Bank of China, which refrained from injecting cash into the financial system for the second consecutive week even as lenders scrambled to meet funding needs.

Money-market interest rates jumped, recalling the severe credit crunch Chinese banks suffered in June. The weighted average of seven-day repurchase agreement rate, a benchmark of Chinese interbank funding costs, rose to 4.77% Thursday from 4.05% Wednesday—the highest since it hit 4.99% July 31.

While technical factors such as the arrival of the corporate-tax-collection season and month-end bank-capital requirements appeared to be driving forces, the PBOC’s inaction looked equally glaring. A week ago the central bank suspended the use of reverse repurchase agreements, short-term loans to commercial banks, for the first time since July 30—meaning it has effectively drained a net 102.5 billion yuan ($16.85 billion) in cash from the financial system in the past two weeks. Some economists consider this a clear signal of potential policy tightening.

“We do not believe that the current rise in the repo rate is being driven by seasonal factors such as the corporate tax payment season….We believe policy tightening is well justified, as [economic] growth rebounded in the third quarter and CPI inflation surprised on the upside in September at 3.1%,” Nomura economist Zhiwei Zhang wrote in a research note.

The PBOC inaction shows it’s keen to maintain a “tight balance” of funding conditions in the banking system, said Mr. Chen from Bank of Dongguan.

“In the foreseeable future, the central bank is expected to stick to this policy direction,” Mr. Chen said, adding that keeping financing costs relatively high is in keeping with Beijing’s effort to make the economy less driven by credit growth and cut overcapacity in industries like steel and shipping.

The PBOC’s move also reflects an intention to offset the inflationary pressures created by surging capital flows into China, said Peng Wensheng, chief economist at China International Capital Corp.

China’s central bank and financial institutions bought a net 126.4 billion yuan of foreign currency in September, compared with 27.32 billion yuan in August, according to calculations by The Wall Street Journal based on central bank data issued Monday. These figures are viewed by most analysts as a proxy for inflows and outflows of foreign capital, as foreign currency entering the country is generally sold to the central bank. September is the second straight month of net purchase—after two months of net sales—suggesting continuing capital inflows.

Despite what traders and analysts describe as aggressive intervention by the PBOC in the currency market, the yuan has appreciated rapidly in recent weeks, setting fresh records almost daily. The yuan traded at 6.0808 to the U.S. dollar earlier Thursday, its highest level ever, up from 6.0835 at Wednesday’s close. The yuan has gained 2.4% against the dollar so far this year, far outpacing last year’s 1% rise.

To slow the pace, the PBOC has to print new yuan notes before purchasing dollars from investors in the foreign-exchange market. To prevent the additional supply of yuan from raising inflationary pressures, the central bank would typically drain cash from the financial system to offset it.