New Fed Chairman Revives Old Problem for China

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SHANGHAI—New Federal Reserve Chairman Jerome Powell surprised some investors with comments suggesting a faster pace of U.S. rate increases this year. He may also have made life more difficult for policy makers in Beijing.

Mr. Powell’s Senate testimony Monday helped push the yield on 10-year U.S. Treasurys to 2.90%, continuing the rise of recent weeks. It is now just 0.92 percentage below the 3.82% yield on equivalent 10-year Chinese government debt, the narrowest gap since last March and well down from 1.67 percentage points as recently as Nov. 23.

In theory, the narrowing could make U.S. Treasurys relatively more attractive and spur outflows from Chinese bonds across the Pacific.

In turn, that could leave China’s central bank with an ugly choice: raise rates itself—as it did three times last year, twice within hours of Fed increases—despite signs of slowing economic growth, or allow the yuan to slide against the dollar.

For sure, China’s strict capital controls will likely stem outflows. Still, the pressure from the narrowing yield gap highlights once again Beijing’s policy “trilemma”—the economic maxim that it is impossible for a country to keep independent control of its currency, interest rates and capital account at the same time. 

While U.S. Treasury yields have risen in recent weeks, Chinese yields have fallen as a confluence of factors has driven up bond prices, which move in the opposite direction. They include the central bank’s efforts to keep the financial system flush with liquidity ahead of the recent Lunar New Year holiday, and a shift of investor funds into bonds as the stock market tumbled earlier this month.

The pressure now on Beijing to track U.S. interest-rate increases may make the recent rally in Chinese government debt hard to sustain.

“The chances are high that the Fed will hike rates again in March, and the PBOC is expected to follow in its footsteps, which will put pressure on China’s bond market,” said Qu Qing, chief fixed income analyst at Hua Chuang Securities.

Beijing has its own reasons to keep monetary conditions relatively tight and borrowing costs high: It has been fighting an uphill battle to cut the country’s worryingly high debt levels and reduce leveraged investment in its capital markets.

The liquidity-pumping tools used by the People’s Bank of China included lowering the level of cash that small rural banks must hold in reserve and making special loans to big banks to keep liquidity abundant in recent weeks.

But in the public money market, it has upheld its tough image: The central bank halted its routine money-market operation for the 16 business days before the mid-February New Year holiday, draining 1.37 trillion yuan ($217 billion) from the financial system by allowing previously issued loans to commercial lenders to expire.