China has a bond bubble on its hands.

I’m not sure how interesting that is for everyday investors — “casual” readers, so to speak — but it’s worth a mention, particularly given the extent to which it’s a reflection of the country’s economic woes and the PBoC’s impossible bind.

10-year yields in China hit a record low on Monday, down around 2.15%.

As the figure shows, the rally escalated in 2024 as growth concerns mounted.

Bonds tend to be bid in a deflationary environment. And China’s struggling mightily to stave off deflation. So vexed is the Party that the subject itself — the “d word,” if you will — is taboo. You can’t even talk about it. Or you’re not supposed to.

The latest consumer and producer price data, covering June, suggested China’s no closer to shaking the deflation demon. Consumer prices managed a meager 0.2% YoY gain and producer prices spent a 21st straight month in deflation.

Worried as they are, and keen as the Party most assuredly is to pull the economy back from the precipice, the leadership (i.e., Xi) seems almost pathologically averse to big-ticket fiscal initiatives. In simple terms: China probably needs helicopter money or, failing that, a set of initiatives designed specifically to revive demand at the household level.

Instead, policymakers have resorted to a patchwork of measures aimed at putting a floor under the property market, the collapse of which is a major factor in explaining an ongoing consumer malaise which manifested last month in a God-awful read on retail sales, which rose just 2% in June from the same month a year ago.

Although policies to support the flailing real estate market have become increasingly aggressive, analysts generally say they fall short of what’s needed. Faced with a seemingly intractable quagmire and unwilling to wield a fiscal bazooka, China’s leaning on the PBoC. Last week, the bank delivered cuts to two key rates: The seven-day reverse repo rate and, three days later, the rate on one-year policy loans (the one-year MLF rate). Chinese banks also lowered the rate on one- and five-year consumer loans.

This is a bit tedious, I know, but bear with me. The late-week cut to the one-year MLF rate was remarkable. It was off-cycle (the PBoC typically conducts MLF operations mid-month) and it was double the size of the cuts to the shorter-term rate and consumer benchmarks. I called it evidence of “panic.” It also served to rekindle the bond rally, or at least complicated efforts to dissuade traders from pushing the envelope, underscoring the tension I alluded to above: It’s hard to arrest a bond rally when you’re cutting rates.

The PBoC’s thus in a bind. They’re under pressure to push borrowing costs lower, but in doing so, they’re emboldening leveraged bets on Chinese bonds. That’d be problematic even if rate cuts were working to support demand in the real economy, but they plainly aren’t. Rather, the rate cuts are just encouraging traders to borrow cheap money for gambling.

The figure above shows a proxy for the cost of financing trades in money markets. It’s the lowest in months.

Absent action on the fiscal side that takes some of the burden for supporting the economy off the shoulders of monetary policy, the PBoC has to play Whac-A-Mole, which in this case means borrowing bonds from banks and selling them to cap yields.

Earlier this month, the PBoC confirmed to Bloomberg that it signed agreements with policy banks to borrow “hundreds of billions of yuan” worth of government bonds which Pan Gongsheng will sell “depending on market conditions.” Traders assumed — and I suppose they had their reasons — that meant the PBoC would be a seller when 10-year yields dipped below 2.25%. Apparently not. Or if they were sellling, it didn’t work.

This has an unmistakable air of farce to it. The PBoC’s cutting rates which, in addition to being fundamentally bond bullish, makes it easier and cheaper for market participants to trade bonds, then turning around and selling borrowed bonds to thwart those trades.

A better approach would be aggressive, debt-funded fiscal stimulus. If Beijing were to borrow say, two trillion yuan, earmarked for some version of helicopter money, it’d put a floor under yields and take some of the pressure off the PBoC to cut rates.

The bond rally is, in the first instance, predicated on fundamentals. China needs to fix the fundamentals. They need to shore up domestic demand. Lowering the cost of money when no one besides traders wants to borrow any won’t accomplish anything. It’ll just create distortions and, as sure as night follows day, bubbles.

I suppose this is obvious, but just in case: You don’t want to get yourself into a situation where government bonds are an egregious bubble because if, for whatever reason, yields reverse too quickly and too dramatically, a lot of people will get saddled with enormous losses. The PBoC’s trying to prevent just that by tapping the brakes on the rally with the sale of borrowed bonds, but as long as they’re compelled to cut rates simultaneously, traders won’t be blamed for staying long. Particularly when liquidity’s ample and getting cheaper by the month.