One day after stocks were this close from hitting new all time highs on what have been either ok earnings, if looking at non-GAAP data, or atrocious earnings, based on GAAP, and where any oil headline is now immediately translated as bullish by the oil algos, so far futures are relatively flat, while European stocks were at their moments ago in anticipation of the latest ECB announcement due out in just one hour.  However, unlike last month’s “quad-bazooka”, this time the market expects far less from Draghi.

“Having pulled put the monetary bazooka in March, the market is sensibly expecting no further policy measures from the ECB,” said Michael Ingram, a market strategist at BGC Partners in London. “Investors are understandably reticent in making big bets ahead of what is on paper, likely to see policy makers firmly on hold.”

Draghi will come and go, but attention will remain on oil and all other commodities, where the Bloomberg Commodity Index headed for a five-month high, spurred by gains from metals to soy beans, and weighing on government bonds.

Nowhere was the ongoing surge more obvious than in the construction complex, where steel reinforcement bars jumped to a 19-month high in Shanghai, buoyed by an improving Chinese property market, supporting the Australian dollar. As seen on the chart below, both iron ore and steel have gone parabolic this year despite, as reported previously, China’s increase in steel output to record highs. “You’ve got a tight market, you’ve got momentum, and you’ve got this fundamental driver for steel in the government boosting the infrastructure and housing side of things,” Chris Weston, chief market strategist at IG Ltd. in Melbourne told Bloomberg. “The rebar price is really leading the iron ore price at the moment.”

Following yesterday’s latest surge in oil which saw WTI overtake the “Gartman doomsday” level of $44, it has since leveled off while Brent fluctuated near $46 a barrel after data showed U.S. production slipped and Iraq said talks to freeze output may occur next month.

Commodity gains boosted the outlook for inflation, sending German bund yields to a four-week high. Sweden’s krona rose after the Riksbank expanded bond buying less than some investors expected. Metal increases boosted European miners, while most industries on the Stoxx Europe 600 Index declined.

“The rally in commodities is making people a bit more positive,” Robin Bhar, an analyst at Societe Generale SA in London, told Bloomberg. “The base metals are gaining on a view that the industrial cycle is strengthening. There’s broad-based buying in commodities, and that suggests that sentiment is starting to turn. This would have drifted across into mining shares and energy stocks.”

Meanwhile in stocks, Europe’s Stoxx 600 slipped 0.5%, after closing at its highest level since January. Miners in the gauge are heading for six-month high. Carmakers rallied, boosted by a 5.1 percent jump in Volkswagen AG after a person familiar with the matter said it agreed to set aside at least $10 billion to resolve civil claims by the U.S. government and lawsuits by American car owners over diesel vehicles rigged to cheat pollution controls.

The MSCI Asia Pacific Index was 1.2 percent higher. Japan’s Topix index climbed 2 percent to a two-month high, buoyed by prospects the Bank of Japan will boost stimulus at a monetary policy review next week. The authority is likely to increase asset purchases, Goldman Sachs Group Inc. analysts wrote in a report published Wednesday. Mitsubishi Motors Corp. tumbled by the 20 percent daily limit in Tokyo after the automaker said it manipulated fuel-economy tests.

S&P 500 index futures were unchanged, indicating U.S. equities will hold a four-month high as investors assess earnings before making a break for fresh all time highs. General Motors Co., Microsoft Corp. and Visa Inc. are among companies announcing quarterly results Thursday.

Where Markets Stand Now

• S&P 500 futures up less than 0.1% to 2100
• Stoxx 600 down 0.4% to 350
• FTSE 100 down 0.5% to 6379
• DAX up 0.1% to 10434
• German 10Yr yield up 6bps to 0.21%
• Italian 10Yr yield up 6bps to 1.46%
• Spanish 10Yr yield up 7bps to 1.6%
• S&P GSCI Index up 0.2% to 353.2
• MSCI Asia Pacific up 1.2% to 134
• Nikkei 225 up 2.7% to 17364
• Hang Seng up 1.8% to 21622
• Shanghai Composite down 0.7% to 2953
• S&P/ASX 200 up 1.1% to 5273
• US 10-yr yield up less than 1bp to 1.85%
• Dollar Index up 0.1% to 94.59
• WTI Crude futures down 0.2% to $44.07Brent Futures down 0.3% to $45.67
• Gold spot up 1.1% to $1,258
• Silver spot up 2.5% to $17.39

Global Top News

• Draghi Can Argue Glass Is Half Full as ECB Pumps Up Stimulus: unemployment is falling and euro-area growth is continuing
• Oil Trades Near 5-Month High as U.S. Crude Production Declines: U.S. crude output falls to lowest since Oct. 2014: EIA
• VW Said to Pay At Least $10 Billion in U.S. Cheating Deal: carmaker’s plan covers lawsuit claims by government, motorists
• Qualcomm Forecasts Are In Line on Progress in China Dispute: stock falls on concern chipmaker may lose Apple orders
• AmEx Profit Beats Estimates as Purchases Climb; Shares Rise: revenue advances 1.6% to $8.09b, in line with estimates
• Yum Brands Profit Tops Estimates as China Unit’s Sales Gain: company raises its annual forecast for operating profit
• Vale Profit Prospects Bolstered by Record Output in Iron Rally: iron output of 77.5m tons is highest for first quarter
• Wal-Mart to Cut Board to 12 Directors as Four Members Retire: board to maintain independent majority at 67% of its members
• BHP Expects Iron Ore Prices to Drop as More Supply Swamps China: co. sees mergers and acquisitions as being unlikely
• Sony Operating Profit Misses Forecast on Smartphone Slump: co. revises outlook ahead of April 28 earnings announcement
• Saudi Arabia Mulls Dual Listing, Traded Fund for Aramco IPO: kingdom seeking ways to broaden investor base for huge IPO
• Companies reporting earnings today include Alphabet, Microsoft, Verizon, Visa, Starbucks, GM

Looking at regional markets, stocks in Asia continued to trade higher as energy continued to drive sentiment following yesterday’s near 4% advance in oil on speculation of a possible producers meeting in May. This saw the energy sector outperform in the ASX 200 (+1.1%) with several firm earnings reports also underpinning sentiment. Nikkei 225 (+2.7%) led the region amid a weaker JPY to climb back above 17000, while Shanghai Comp (-0.7%) is also positive after a larger liquidity injection by the PBoC, although overheating credit concerns capped gains. JGBs saw mixed trade with 10yr JGBs mildly lower amid strength in Japanese stocks, while yields in the super-long end declined with the 30yr yield at fresh record lows. Furthermore, today’s 20yr auction was better received but failed to provide lasting support.

Top Asia News

• Soros Says China’s Debt-Fueled Economy Resembles U.S. in 2007-08: Surging new credit is warning sign, Soros says
• The 54% Rally in Steel Prices That Points to China’s Rapid Shift: Iron ore, steel demand getting better, Credit Suisse says
• Japanese Funds Return to Overseas Bonds After Two Weeks of Sales: Purchases total net 844.7b yen in latest week, MOF says
• Hony Capital Is Said to Raise $2.7 Billion for Yuan-Dollar Fund: Will be first dual-currency fund raised by large PE firm
• Hong Kong Stocks Scorn Economic Gloom as Bull Market Approaches: MSCI gauge of city’s shrs has rallied 17% since January low
• ‘Shameful’ Mitsubishi Fraud Risks Pushing Carmaker to Brink: Data manipulation affects ~625,000 minicars in Japan
• ‘Black Box’ India States Thwart Modi Moves to Lower Debt Costs: Nomura sees deficits of major states widening to 3.3% of GDP

Equity specific news has taken focus so far in European hours, with macro news relatively light as participants await the ECB rate decision and press conference later today. In terms of European equities, this morning has been mixed in terms of indices, with Euro Stoxx higher by around 0.25%. Earning season appears in full flow, with Ericsson lower by around 10% after announcing a profit warning pre-market, with the likes of Pernod Ricard also among the worst performers after a pre-market earnings update. Separately, Volkswagen are the best performing stock in Europe today after agreeing a deal with the US regarding the emissions scandal.

Bunds have grinded lower throughout the session so far, with a number of analysts attributing the move below 163.00 to technical selling and positioning ahead of the ECB meeting later today. The commodity complex has seen WTI trade in a relatively tight range this morning in the wake of the significant gains seen so far this week, with the US benchmark remaining above the USD 44/bbl level.

European Top News

• Novartis Profit Falls as Blockbuster Cancer Drug Sales Drop: company reiterates full-year forecast for sales and earnings
• Ericsson Shares Drop Most in Year After Sales Miss Estimates: competition from Nokia, Huawei putting pressure on margins
• Billionaire Slim Said to Weigh Stake Sale of Dutch Carrier KPN: sale could attract phone companies, such as Orange
• SABMiller Sales Advance on Gains in Africa, Latin America: organic beer volumes rise 3% in fourth quarter
• Pernod Ricard Suffers China Setback as Scotch Demand Ebbs: sales in China unexpectedly dropped 5% on weak New Year orders
• Anglo’s Refined Platinum Output Drops as All Forecasts Kept: quarterly diamond production fell 10% as De Beers cut supply
• Fnac Bids $1.1 Billion for Darty, Countering Steinhoff Offer: investors would receive 145 pence in cash or share alternative
• U.K. Retail Sales Fall More Than Forecast; Budget Target Missed: U.K. retail sales fell for a second month in March
• Sweden Fights Currency Market With More Monetary Stimulus: Riksbank to increase quantitative easing program by SK45 bln
• Hapag-Lloyd Said to Be in Merger Talks With Competitor UASC: cos. said to be in talks as they fight increasing competition
• Italy Bank Fund Approved by Regulator, Reaches Money Target: Atlante fund exceeded goal of raising EU4b

In FX, fresh EUR sales seen ahead of the ECB meeting today, where little change is expected to the current measures in place, but all the focus on the following press conference — from which we saw the huge FX moves in March. Moves lacking any momentum though as yet, and through 1.1300, fresh lows are met with snapbacks to highlight indecision. UK retail sales were the key data release, coming in weaker than expected, but were offset by lower public borrowing requirements. GBP was sold into the release aggressively, but after a reluctant dip under 1.4300, we are back in the mid 1.4300’s. Ongoing consolidation in the commodity linked currencies, with USD/CAD finding some support ahead of 1.2600 and now edging back towards 1.2700. WTI
(Jun) is still trading on a $44.0 handle — just — but near term calm is enough ease CAD strength for now. USD/JPY continues to hold off 110.00, but is equally well bid on modest dips, with positive equities and the BoJ meeting next week lending some support

In commodities, WTI may have met a key resistance level of USD 44/bbl (which is also the 50% retracement from the Apr’15 highs to the Feb’16 lows) after yesterday’s strong rally after OPEC announced they are set to call another meeting to revive output freeze/cut talks. Also of note today sees the release of the EIA natural gas with the previous result at -3 this comes after NatGas futures have slightly retraced after declines in recent months . Gold has been moving higher and has now broken a key resistance level of USD 1257.90/oz, also Silver has been making strong gains breaking through the USD 17.50/oz this morning , this comes amid broad-based strength across commodities which also saw copper and iron ore extend on gains, with Dalian iron ore futures hitting limit-up at a 19-month high alongside Shanghai rebar’s 7% advance, following supply cuts by large industry names.

The US calendar picks up notably today. We kick off with the Chicago Fed national activity index, Philly Fed manufacturing survey and the latest initial jobless claims data, before there’s more house price data in the form of the FHFA house price index, before concluding this afternoon with the Conference Board’s leading index (where a +0.4% mom gain is expected). The BoE’s Carney is due to speak again this afternoon, while it’s a bumper day for earnings across the pond. 37 S&P 500 companies are scheduled to report including Alphabet, General Motors, Verizon, Microsoft and Schlumberger.

Bulletin Headline Summary from Bloomberg and RanSquawk

• European equites trade in a relatively tentative manner ahead of the ECB rate decision and press conference with Bunds slipping below 163.00
• Ahead of the ECB, FX moves are currently lacking any momentum with fresh lows in EUR/USD met with snapbacks, thus highlighting indecision
• Focus going forward though will remain on the ECB, although other highlights include Philadelphia Fed business outlook and possible comments from BoE’s Carney
• Treasuries rise during overnight trading, a continuation of the late afternoon selloff in New York amid rising commodities and equities; ECB policy announcement due at 7:45am ET, followed by press conference at 8:30am.
• With no new measures expected at Thursday’s meeting, Mario Draghi may use his press conference to point to signs that negative rates, free bank loans and a 1.7 trillion-euro ($1.9 trillion) bond-buying program should be enough to revive euro-area inflation
• Swedish policy makers delivered a little more stimulus and made a few predictions about the future though all they can do now is hope ECB President Mario Draghi doesn’t upend everything for those outside the euro zone struggling to protect their currencies
• Bank of Japan Governor Haruhiko Kuroda’s concerns about a rising yen are shared by senior officials at the central bank, according to people familiar with the discussions
• Gold may advance to as much as $1,400 an ounce over the next 12 months, according to BNP Paribas SA, which cited rising investor concern about the efficacy of central banks’ policies to sustain growth
• Global investors have cheered the recent signs of economic pickup in China. Andrew Colquhoun is unimpressed. The head of Asia Pacific sovereigns at Fitch Ratings sees the growth spurt, fueled by a resurgence in borrowing, threatening to wreak havoc on the financial system
• Billionaire investor George Soros said China’s debt-fueled economy resembles the U.S. in 2007-08, before credit markets seized up and spurred a global recession; said China’s March credit-growth figures should be viewed as a warning sign

(Harvey:  see Soros’s  comments below)

• China’s top fixed-income fund manager said she may cut holdings of onshore corporate notes after defaults surged in the world’s third-biggest debt market
• U.K. retail sales posted their biggest monthly decline in more than two years in March as Britons bought less of everything from food to clothing; Office for National Statistics also revealed that debt as a share of the economy rose
• Sovereign 10Y bond yields higher; European, Asian equity markets mostly lower; U.S. equity-index futures rise. WTI crude oil, metals mostly higher

DB’s Jim Reid concludes the overnight wrap

Welcome to ECB meeting day, 6 weeks on from Draghi’s policy bazooka. In the PDF today we’ve updated our performance review chart to track global assets since this point. Of particular interest to us is where European assets are in the mix. When we last ran this nearly two weeks ago returns for European assets had been relatively weak post-ECB with many of the areas of the market Draghi had tried to help having underperformed. The last 14 days have seen a marked turnaround in sentiment however and now all of the European assets we look at are back in positive territory over the relative time frame. In bond markets Bunds have returned just shy of 1% with Spanish bonds now catching up and matching on a total return basis. BTP’s are just in positive territory (+0.3%) but have underperformed with the Italian banking concerns. Performance for equity markets has been strong with the Stoxx 600 now up +4% which is a marked turnaround from -3% of two weeks ago. Regionally it’s the DAX (+7%) which leads the way (and ahead of the S&P 500 which is up +6%), followed closely by the peripheral bourses of Portugal (+6%), Greece (+6%) and Spain (+5%) with the FTSE MIB (+3%) lagging behind. European banks have staged a huge turnaround of late also and are now positing a +2% gain, which is an +11% or so swing from two weeks ago. It won’t come as much surprise to hear that EUR credit has continued to remain well supported with EUR HY (+4%), EUR IG Non-Fin (+2%) and EUR Fin Sub (+2%) all in low single digit return territory and out-performing bunds. That said it’s interesting to see that EUR credit has generally underperformed its US counterparts by a percent or so, reflecting the lower energy exposure over a period of a large rally in Oil prices (WTI +11%).

Perhaps of most interest to us today will be evidence of any logistical progress on the corporate bond purchasing program (CSPP). Since the announcement date details for the program have been thin with the hope that today will bring greater clarity around the potential size, split between primary and secondary markets and the finer details around bond eligibility. It might still be too early to hear much though. A report from Michal Jezek in my team, which we attach the link below to, shows that ECB eligible eurozone bonds initially outperformed post the ECB CSPP announcement and in the two weeks or so after. However since then they have underperformed non-eurozone bonds almost to the same magnitude. The turnaround has coincided with a higher beta global rally over the last two weeks or so, so that’s certainly helped the performance of the generally wider higher beta non-eurozone issues. We also provide a list of the top and bottom 100 bonds by performance since the ECB announcement.

Outside of the ECB today the main topic for markets continues to be Oil which is clearly the dominant driver for price action at the moment. Last night saw WTI close +3.77% at $42.63/bbl and so eclipsing the highest price for the year. That means Oil is now just over +13.5% up from the post-Doha early Monday morning lows now, or nearly $5. It’s worth noting that we roll onto the June contract today which is currently trading around $44/bbl this morning (and unchanged). Yesterday the early concerns from the announcement of the end of the Kuwait oil strike was quickly forgotten about post the latest EIA data which showed inventory levels coming in lower than expected and which appeared to be enough to fuel the rally. Later on we also saw headlines filter through suggesting that OPEC and other crude producers could meet as soon as next month in Russia in a bid to restart production freeze talks according to Iraq’s deputy oil minister.

With little other news flow, the rally in Oil has seen most markets in Asia this morning get off to a solid start. It’s Japan which is currently leading the way with the Nikkei +2.51%, while elsewhere there are decent gains for the Hang Seng (+1.79%), Kospi (+0.63%) and ASX (+0.91%). Bourses in China are back to flat after initially opening in the red while credit markets in Australia and Asia are generally a couple of basis points tighter.

In fact it was a broadly better day for commodities all round yesterday. The rest of the energy complex rallied in vain, while base metals also bounced (Aluminium +2.21%, Copper +0.91%, Nickel +0.59%). Iron ore also rallied another 3% and has quietly surged over 11% this week alone to the highest level since June last year. A big rise in Chinese steel demand has coincided with the rally, while the supply side of the equation has also been given a boost with production reports from the big mining names this week (BHP, Rio Tinto and Vale) all hinting at lower production guidance this year and next.

As a result of gains in the commodity space, along with another decent day for financials, it ended up being another positive day for risk markets generally yesterday. European equity markets rallied back from a weak open, with the Stoxx 600 closing +0.43% for its third consecutive daily gain. A late dip into the close meant gains were more modest in the US (S&P 500 +0.08%) but the Dow and S&P 500 continue to extend the recent highs. US credit markets were the big outperformer. In the CDS space CDX IG closed nearly 3bps tighter and to the strongest level since August last year, while in the cash market we saw US HY energy spreads finished nearly 30bps tighter and are all of a sudden over 60bps tighter in two days. Earnings reports appeared to be less of a factor driving markets yesterday but we’ve got a number of tech heavyweights reporting today as well as the first hint of earnings in the energy sector when Schlumberger report after the close – it’ll be worth keeping an eye on those numbers.

There wasn’t a whole lot of economic data for us to digest yesterday. The only data we did get in the US was in the form of more housing data, although in contrast to some of the softer reports earlier this week, yesterday’s existing home sales print of +5.1% mom was ahead of expectations (+3.9% expected) with the annualized rate ticking up 5.3m from 5.1m in February. Treasury yields moved higher and the benchmark 10y (which rose 6bps) finished at 1.846% and the highest yield since March. Interestingly, we also noted that the Bloomberg US financial conditions index was up nearly 6bps yesterday, indicative of easing of financial conditions, with the current level suggesting that conditions are now easier than when the Fed moved to hike back in December.

The rest of the economic data of interest yesterday was in the UK with the latest employment readings. The unemployment rate was reported as holding steady at 5.1% in February as expected, while the change in employment growth of 20k in the three months to the end of Feb was less than hoped for (60k expected). Of perhaps most importance was the softer than expected earnings data. Average weekly earnings including bonuses printed at +1.8% yoy, well below expectations (+2.3% expected) and down three-tenths from the prior month. That said there was no change in the earnings data stripping out the effect of bonuses.

Taking a look at the day ahead, the highlight this morning datawise will likely be the March retail sales numbers for the UK, while French confidence indicators are also due out. The aforementioned ECB meeting is due at 12.45pm BST with President Draghi due to speak shortly after, while the Riksbank will also hold their own policy rate decision (no move expected). Over in the US the calendar picks up notably today. We’ll kick off with the Chicago Fed national activity index, Philly Fed manufacturing survey and the latest initial jobless claims data, before there’s more house price data in the form of the FHFA house price index, before concluding this afternoon with the Conference Board’s leading index (where a +0.4% mom gain is expected). The BoE’s Carney is due to speak again this afternoon, while it’s a bumper day for earnings across the pond. 37 S&P 500 companies are scheduled to report including Alphabet, General Motors, Verizon, Microsoft and Schlumberger.

China’s credit growth in March (and $1 trillion surge in total social financing in Q1) is a “warning sign” according to billionaire George Soros, “because it shows how much work is needed to stop the slowdown.” Speaking at an event in new York this evening, Soros commented on “troubling developments” in China, the anti-corruption drive’s impact on capital outflows and the real-estate bubble “feeding on itself.” His conclusion, rather ominously, was that despite all the naysayers and fiction-peddlers, China “resembles US in 2007-8,” before credit markets seized up and spurred a global recession.

As Bloomberg reports, Billionaire investor George Soros said China’s debt-fueled economy resembles the U.S. in 2007-08, before credit markets seized up and spurred a global recession.

China’s March credit growth figures should be viewed as a warning sign, Soros said at an Asia Society event in New York on Wednesday. The broadest measure of new credit in the world’s second-biggest economy was 2.34 trillion yuan ($362 billion) last month, far exceeding the median forecast of 1.4 trillion yuan in a Bloomberg survey and signaling the government is prioritizing growth over reining in debt.

 

[ZH – f one adds up the Total Social Financing injected in the first quarter, one gets a stunning $1 trillion dollars in new credit, or $1,001,000,000,000 to be precise, shoved down China’s economic throat. As shown on the chart below, this was an all time high in dollar terms, and puts to rest any naive suggestion that China may be pursuing “debt reform.” Quite the contrary, China has once again resorted to the old “growth” model where GDP is to be saved at any cost, even if it means flooding the economy with record amount of debt.

 

With China’s debt/GDP already estimate at 350%, how much longer can China sustain this stunning debt (and by definition, deposit) growth continue?]

 

Soros, who built a $24 billion fortune through savvy wagers on markets, has recently been involved in a war of words with the Chinese government. He said at the World Economic Forum in Davos that he’s been betting against Asian currencies because a hard landing in China is “practically unavoidable.” China’s state-run Xinhua news agency rebutted his assertion in an editorial, saying that he has made the same prediction several times in the past.

Soros then went on to note that China’s capital outflow is a growing phenomenon driven by the nation’s anti-corruption campaign, which makes people nervous and spurs them to pull money out, and added that…

China’s decoupling of the yuan from the U.S. dollar can help rebalance the currency.

 

The linking to a basket of currencies is a “very positive, healthy” development for world.

Finally in an ironic twist for a man who has all too often used the press for his own ends…

China’s lack of a free press is “troubling development”.

Of course one should bear in mind that Soros is among those who are betting heavily on the eventual devaluation of The Yuan against the USD, and as we noted previously, the cracks are starting to show… As the Chinese corporate bond market begins to break…

At least 64 Chinese firms have postponed or scrapped planned note sales this month, six times more than the same period a year earlier.

And as BofA’s David Cui explains, if poorly handled, they may cause significant financial instability…

Since 2015, eight SOE bond issuers have run into repayment problems; four since February. We believe that the sharply accelerating pace and the growing chance of genuine defaults are largely behind the recent widening of credit spreads (Bond yield rising, credit spread widening & impact on stocks, Apr 15). In our view, any major SOE bond default would be difficult for the financial system to handle – as it is unexpected, it could lead to panic selling/a credit crunch (2016 Year-Ahead: what may trigger financial instability, Jan 3). At this stage, we expect that most problematic SOE bonds, if not all, will get largely bailed out. But this is a key risk that we need to monitor for the equity market outlook.

Chart 1 shows the dates when the potential defaults were first reported vs. the credit spread of 5Y AA-rated enterprise bonds (more details on the bonds, Table 1). Among the eight, Tianwei, Erzhong, Sinosteel, China Coal Huayun and China Railway Materials are central SOEs; Guangxi Nonferrous, Yun Feng and Dongbei Special Steel are local ones. The media reported that some of these SOEs actively sought defaults in order to lessen their debt burdens – a few even reshuffled their assets in preparation (Caixin, Apr 18). This clearly raises the chance of genuine defaults in the bond market’s mind, in our view.

Based on our assessment, the dynamics among the key stakeholders are as follows: some SOEs want to default; many local governments may lack the financial resources to save their SOEs from defaulting; the central government has the resources (after all, it can print), but needs to balance short-term financial stability with moral hazard concerns; the bond underwriters, many of them banks that lend to the same SOEs, need to balance financial interests against the risk of reputation damage and potential lawsuits; bond holders may go on a buying strike to force bail-outs.

At this stage, we expect the central government and the bond underwriters to largely come up with the money to prevent any significant default of SOE bonds. It appears to us that, leading up to the 19th Party’s Congress in late 2017 (when a new group of leaders will be officially announced), a top priority of the central government is to prevent a financial crisis. For banks, the cost of bail-outs could be hidden for quite some time, so the incentive for them to suppress defaults is strong, in our view. Actually, there was at least one case in which a listed bank used its WMP under management to cover a defaulting bond ((Shadow banking default, pace accelerated sharply since mid-2015, Apr 7).

If our expectation is right, the bond market could calm down as soon as it sees signs that bail-outs are the likely scenario. This would kick the can down the road, using liquidity to paper over a solvency issue.

If, against our current expectation, the government/underwriters keep in mind:

Implicit guarantee & contagion risk: SOEs default on loans all the time, but banks don’t “panic” unless there is a deposit run. However, the same stability cannot be maintained as easily in the shadow-banking sector. The shadow-banking sector is largely a market where greed, fear and herd mentality reign supreme. For years, bond buyers believed that bonds issued by any government-related entity, including SOEs and LGFVs, were bullet-proof. If this perceived “implicit” guarantee is broken, at a minimum, credit spreads would widen sharply and, at the worst, panic selling could develop, generating a negative spiral. Moreover, contagion risk could be high: if this “promise” is broken, will the market still believe in perceived government guarantees elsewhere, including those on RMB, the A-share market or housing prices?

 

Expensive valuation: before the latest widening, credit spreads for AAA and AA+ rated LGFV bonds and enterprise bonds (largely SOEs’) were very narrow, at between 50-100pbs. As a result, the risk of holding on to these bonds is asymmetrical, unless one believes that the government will lower the risk-free rate significantly going forward (Bond yield rising, credit spread widening & impact on stocks, April 18). As a result, the market is biased toward selling at the moment, by our assessment.

 

Leverage: the more transparent part of bond leverage is via repos and structured funds, which appear manageable at this stage (Bond market: leverage & potential defaults, 23 Oct 2015). However, a risk is that there could be significant amount of hidden leverage. Anecdotally, some banks provide loans to WMPs under their management to buy bonds, so the WMPs can achieve the “promised” returns to WMP buyers (currently, around 4% p.a.)

 

A lack of transparency: the most important buyers of bonds in China include WMPs managed by banks, brokers and fund subsidiaries, banks themselves, money market funds and bond mutual funds, and insurers. While risk responsibility is clear-cut for most bond buyers, it is not so for the WMPs. Legally speaking, WMP buyers own the downside risk. However, the way that WMPs are sold in China has led many buyers to believe that these products are essentially term deposits. As a result, if financial institutions decide to pass on some of the default losses to these buyers, they may stop buying en masse, essentially generating a “bank” run in the shadow-banking sector (Risk of bank-run WMPs is rising, Feb 28). By the way, if the financial institutions, including banks, allow some SOE bonds to default, they will most likely pass on at least some of the losses. If they have to bear the losses themselves, they’d be much better off bailing out the bonds in stealth before the defaults, both financially and politically.

Even without a panic, if the bond market becomes more cautious as a result of SOE bond defaults, there could be negative implications on credit flow, credit cost, economic growth, commodity demand, the RMB and the stock market.