China Insight: Watch PBOC Policy U-turn as Trade War Intensifies

China has been in the spotlight year to date, largely in regard to the pick-up in credit stimulus and growth data in recent months. Given the improving growth momentum in Q1 and rising inflation pressure, the signals given by the People’s Bank of China (PBOC) in April reflected policymakers' growing bias for a less accommodative monetary policy stance in H2. However, the drastic turnaround of trade negotiations in the week ending 12 May was totally out of expectations. This, we think, will inevitably hurt investor sentiment and business confidence, as the markets had been expecting a trade deal until the 11th round of the US-China trade talks ended up with no agreement but an increase in tariffs.

With the US-China trade war intensifying, it is quite likely that PBOC's policy response will turn more accommodative again in order to offset trade stresses. An unexpected targeted RRR cut announced on 6 May was the first easing move, especially in context of a hawkish message that came out from the 1Q19 PBOC Monetary Policy Committee meeting just one month ago.

Chart 1 shows that Chinese government bond (CGB) yields have been very responsive to the change in trade stresses since the outbreak of the US-China trade disputes in Q1 2018. We think such a market dynamic will repeat itself this time around too.

In our view, the 10-year CGB yield, currently at 3.28%, will re-see 3.15-3.20% before Trump meets with Xi at the G20 summit in Osaka in late-June. Recall that we did see a one-way slide of CGB yields in November last year before both leaders had a dinner together at the G20 summit in Buenos Aires at the beginning of December. That unavoidably will result in further extension of the USD/CNH's rally for 6.95 or even 7.00 during this summer.

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