Due to the rapid rise in U.S. bond yields and the widening interest rate gap between China and the United States, the arbitrage space for RMB bonds has shrunk rapidly, leading to significant reductions by foreign capital. According to the latest data from the People's Bank of China, as of the end of November, the scale of bonds held by foreign institutions in China's interbank market fell to 4.15 trillion yuan (approximately $569.78 billion), a decrease of about 100 billion yuan from October. This marks the fourth consecutive month of reduction in foreign holdings since reaching a record high of 4.52 trillion yuan in August of this year.
The China-U.S. Interest Rate Gap Widens Rapidly, Arbitrage Trading Loses Momentum
As of December 23, the yield on China's one-year government bonds stood at 0.85%, a new low; influenced by the hawkish signals from the Federal Reserve, the U.S. one-year government bond yield soared to 4.295%, a new high since September of this year, further widening the China-U.S. interest rate gap to 3.445%. This change renders the previous swap point-based arbitrage strategy unviable.
In the first half of the year, foreign investors took advantage of the deeply negative swap points of the USD/RMB to convert U.S. dollars into RMB through the foreign exchange swap market, reinvesting in Chinese interbank certificates of deposit and government bonds to enjoy excess spreads. However, with the rapid rise in U.S. bond yields, this excess spread has been completely eroded. According to calculations, the current implied interest rate difference in the swap points is -3.39%, lower than the actual interest rate difference of -3.445%, reversing the previously available arbitrage opportunities.
Foreign Investors Reduce Holdings in RMB Bonds, Domestic Institutions Dominate the Market
In the RMB bond market, foreign investors already accounted for a small share, currently holding 2.7% of China's interbank bond market. As arbitrage trading subsides, market dominance returns to domestic institutions. Bond traders generally believe that the recent bond market trend is strong, but with rate cuts and interest rate cuts yet to materialize, the market has already priced in a rate cut expectation of more than 30 basis points, which may lead to short-term volatility.
In December, the yield on China's 10-year government bonds fell below 2% for the first time, followed by the 30-year government bond yield touching the 2% threshold, and last week, the one-year government bond yield fell below 1%. With expectations of a loose monetary policy, market funds continue to flow in, but the unfulfilled rate cuts aggravate volatility.
U.S. Bond Yields May Remain High, Difficult to Narrow China-U.S. Interest Rate Gap
In the foreseeable future, U.S. bond yields may remain high. The Federal Reserve's latest forecast shows that the number of rate cuts next year will be reduced from four to two or three times, while the Personal Consumption Expenditures (PCE) inflation is expected to rise to 2.5%, higher than the previous 2.1%. This change may be related to the policies of the incoming Trump administration, including potential tariff adjustments and economic growth stimulus plans.
Furthermore, the debate within the United States over the debt ceiling is intensifying, with clear divisions within the Republican Party regarding fiscal policy—one faction advocating for strict control of the debt ceiling, while another favors tax cuts and relying on economic growth for budget balancing. These uncertainties may further push up long-term interest rates.
Bond Market Volatility Increases, Institutions Adjust Strategies
In the domestic bond market, recently, some institutions have opted to take profits by reducing long bond holdings, with rural financial institutions and insurance funds stepping in to buy. Market participants believe that although expectations of rate cuts and interest rate cuts support the bond market, short-term volatility may increase. Last week, influenced by news urging the central bank to curb aggressive trading, the bond market saw a brief sell-off, which was followed by a rebound in yields due to loose funding conditions and heightened expectations of rate cuts.
Overall, the inflow of foreign capital into the RMB bond market has temporarily stalled due to the reduced arbitrage opportunities, with future rate cuts becoming a key driver for the market. As the China-U.S. interest rate gap remains wide, domestic institutions tend to gradually increase long bond holdings amid adjustments. The bond market may maintain short-term volatility, requiring attention to policy dynamics and changes in market capital flows.
