How will the Chinese Central Bank Respond to the Fed Rate Hike?
By Suyang Zhou - Research Analyst
US Federal Reserves will host a monetary policy meeting this Wednesday, March 21. Fed Watch shows that the probabilities for a target rate hike stood at 91.6% as of March 20. How will the Chinese Central Bank respond to a highly probable Fed rate hike?
We believe the Chinese central bank PBOC is very likely to raise open market operation (OMO) rates should the Fed increase the fund rate. First of all, the Chinese real economy functioned well in January and February, with bullish performance in retail sales, investment, and industrial production on both year-over-year (y-o-y) or month-over-month (m-o-m) bases. Meanwhile, CPI accelerated to 2.9% y-o-y in February, allowing sufficient room for an OMO rate hike.
Secondary, 10-year treasury spreads between China and US have been gradually shrinking in recent months, while the value of the Chinese Renminbi is standing high against the US Dollar since exchange rate reform in August 2015. Therefore, China needs to keep in step with the US this time to help stabilize treasury spreads and the exchange rate (hence prevent capital outflows) in light of a more hawkish monetary stance from the US Fed.
The market has priced in an OMO rate hike, yet has not reached consensus on the extent and pace. We project there would be at least a 10 bps increase this time, and in total three rate hikes in 2018. Similar to last year, the PBOC is likely to raise OMO rates twice in 1H2018 and once in 2H2018, as there could be more economic headwinds in the second half.
Currently, 10-year treasury spreads between China and US have shrunk to 100 bps, very close to the level in Jan-Feb 2017. In February and March 2017, the PBOC raised OMO rates twice by 10 bps each. This one is more timely, as central banks have more coordination in interest rate normalization given a synchronized recovery in the world economy. A 10 bps (or more) increase in Chinese OMO rates not only follows the global normalization trend, but also sticks to monetary neutral and financial deleveraging stances, which can effectively hedge against capital outflow risk.
On the other hand, the US labor market saw bullish employment and payroll rises, thereby lifting inflation expectations. This exacerbates upward risk in US treasury yields. By contrast, a newly issued Chinese Household Survey shows that ONLY 26.4% of domestic urban citizens have an inflation expectation, which contradicts recent views from the PBOC that ‘there could be upward pressure on inflation’. Therefore, the PBOC needs to keep up with the Fed pace to maintain treasury spreads at a reasonable level and recalibrate inflation expectations in the domestic market.
However, we believe there is a low probability for a benchmark interest rate hike, which would send a strong tightening signal to the market. After all, the Chinese economy and inflation are not overheated, and the financial market remains tight.
On the inflation side, inflation pressure indeed exists, but not excessively. The major drivers for CPI are food price inflation and core inflation. Annual CPI for 2018 would climb higher towards (but not reach) 3%. By contrast, PPI lacks drivers mainly because the base effect would quickly fade away in 2018 given the soaring PPI level last year, and because investment demand would weaken in light of disciplined fiscal spending. Divergence between PPI and CPI would shrink dramatically. Their weighted average, the GDP deflator, is expected to remain stable this year.
On the financial market side, a tightened financial condition puts downward pressure on expansion of total social financing and Renminbi loans. Nominal GDP growth has surpassed M2 growth for the first time since 2012, signaling a tightened monetary stance. Additionally, after three OMO rate hikes last year, China’s weighted average lending rate has gone up, a clear sign that real economy is affected. Thus, there’s no need to increase the benchmark interest rates in the near term.
In summary, we expect monetary policy to remain neutral in 2018. In other words, the PBOC will raise OMO rates rather than benchmark interest rates to respond to Fed rate hikes, and meanwhile use targeted RRR cuts to keep domestic economy resilient.