Possible Chinese Default And Thorny Issues Lead To Lower Government Bond Yield

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Evergrande, a highly leveraged Chinese property company in danger of default, sent investors scrambling on Monday, shedding risky assets and shifting into safe-haven government bonds.

Yield on the benchmark 10-year Treasury plunged nearly 6 basis points yesterday, to about 1.312%, after surging last week when the consumer price index registered a slowdown in inflation and August retail sales came in stronger than expected.

There was talk of a “Lehman moment” for China—referring to the US government decision in 2008 to let Lehman Brothers collapse, amplifying the financial crisis —if Beijing follows through on its pledge not to rescue Evergrande, which has an estimated $300 billion in debt. A default could destabilize the Chinese economy and lead to repercussions globally.

In Europe, yield on the benchmark 10-year German bond also fell on Monday, declining to minus 0.3240% after rising to above minus 0.2750% last week amid concerns about eurozone inflation.

A report that the chief economist for the European Central Bank, Philip Lane, had told some analysts that inflation could hit the ECB’s 2% target sooner than expected and lead to interest-rate increases in 2023, a year earlier than anticipated, unsettled investors and pushed up government bond yields last week. The ECB called the report inexact, but the damage was done.

France’s 10-year bond yield fell to below 0.2% Monday after surging above 0.5% last week. Paris is engaged in a diplomatic bras-de-fer with Washington after the US announced it was going to help Australia build nuclear submarines, killing France’s multibillion-dollar deal to provide conventional submarines.

The French brouhaha is just one of many issues challenging a White House still reeling from the  botched Afghanistan withdrawal as President Joe Biden’s domestic agenda is running into headwinds from Congress. On top of that, a sudden influx of Haitian immigrants into Texas worsened a bad border situation and forced Washington to start repatriating them.

Treasury Secretary Janet Yellen warned that a failure by Congress to raise or suspend the debt ceiling, which came back into effect July 31 after being suspended during the pandemic, could trigger a US default and “precipitate a historic financial crisis.” The US public has seen this kind of brinksmanship before, but this time the issue is exacerbated by Democrats’ determination to push through a $3.5 trillion spending bill against Republican opposition.

The debt ceiling issue adds to investor uncertainty as the Fed’s policy committee meets this week and is widely expected to offer some indication about its plans to scale back its bond purchases. Economic projections by the members of the Federal Open Market Committee could also show higher inflation expectations and a shorter time horizon for raising interest rates.

The S&P 500 stock market index fell more than 100 points at one point on Monday, hitting near 4,300 before recovering some ground in afternoon trading as Evergrande accelerated a downward trend.

In principle, the prospect of the Fed tapering bond purchases should lead to weaker Treasury prices and higher yields, but the uncertainty about the debt ceiling and government spending are supporting prices. Add in the possibility of a huge Chinese default, and you have the right mix for declining yields.

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