China's bond market doesn't believe inflation is under control

01/19/2011 6:38 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Yes, China has a government bond market. It even has a yield curve. And right now the bond market and the yield curve are signaling worries about inflation just ahead of the release of China’s report on fourth quarter GDP growth.

Economists project that China’s economy grew by 10.2% in 2010. That would be the fastest growth rate since 2007.

Yesterday the yield on China’s 3.77% coupon 10-year bond due in December 2020 rose to 3.95%. (Remarkably the yield on the 10-year U.S. Treasury is just 3.37%.) The yield on China’s two-year note fell to 3.24%. (The yield on the two-year U.S. Treasury note is just 0.58%.)

It’s the move up in yields on the 10-year bond and down on the two-year note that signals worries about inflation. When bond investors start to anticipate rising inflation, they ask for higher yields on longer-term bonds because rising inflation will have more time to eat into the value of those bonds and their payout over the longer life of the bonds.

Yesterday the difference between the yield on the 10-year bond and on the two-year note widened to 0.71 percentage points. That’s an increase from the 0.48 percentage point spread on January 4.

It’s particularly significant that the spread is widening even though the most recent inflation numbers show inflation falling in December from November’s level. For December inflation dropped to a 4.6% annual rate from 5.1% in November. November’s 5.1% rate was the highest in the last 28 months.

I’d have to conclude that the bond market, at least, doesn’t believe that December’s drop is likely to last or that inflation is under control.

Fueling that skepticism are reports that bank lending soared in the first two weeks of January. New bank loans may have reached 1 trillion yuan in the first two weeks of the year, Goldman Sachs estimated last week on the basis of checks with China’s banks. In comparison, calculates Barclays Capital, the People’s Bank of China locked up about 360 billion yuan in bank reserves when it raised bank reserve requirements at the very end of December.

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