China Trapped in Deflationary Quagmire, Sovereign Yields Hit Nine-Month Highs, Spotlight on Monetary and Fiscal Stimulus

Equity Rally Weakens Bond Market Appeal
Focus on Possible PBOC Bond Purchases
5% Growth Target in Doubt, Policy Support in Focus

China’s sovereign bond market is reeling under deflationary pressure, with mounting expectations that the People’s Bank of China (PBOC) will soon resume government bond purchases to inject liquidity, dampening investor appetite for bonds.

Surge in 10-Year Bond Yields

According to the South China Morning Post (SCMP) on the 17th, China’s benchmark 10-year government bond yield climbed to 1.806%, the highest in five months, reversing a 17-basis point decline over the past three months. By contrast, the CSI 300 equity index surged 17% in the same period, underscoring investor preference for equities over bonds.

Analysts attributed the retreat from China’s bond market to growing expectations that the PBOC may restart interventions suspended since January. Xing Zhaopeng, senior China economist at Australia & New Zealand Banking Group, said, “There is speculation that the PBOC could resume trading in five-year bonds, which is stabilizing the market. Purchases could start as early as this month.” China Securities Journal also cited analysts noting heightened anticipation for a renewed round of bond purchases.

With capital flowing into equities, sentiment in the bond market has weakened. Since late June, the 10-year yield has risen about 25 basis points, while the 30-year yield climbed above 2.1%, its highest since November. Investor appetite was further undermined by a recent proposal to overhaul performance-linked mutual fund fees, which has reduced demand for lower-yielding bonds.

A renewed round of PBOC purchases would be instrumental in restoring investor confidence. Rising sovereign yields are also pushing up government borrowing costs, adding urgency for intervention. Since last year, China has employed bond transactions as a new monetary policy tool for liquidity management. The PBOC conducted net purchases for five consecutive months from August through January, before suspending them.

Marked Slowdown in H2 Growth

Calls for fiscal support are also intensifying as China’s growth momentum falters. According to the National Bureau of Statistics, industrial output in August rose 5.2% year-on-year, below the 5.7% consensus forecast and down from 5.7% in July. Output growth has steadily weakened since peaking at 7.7% in March, with the August figure marking the lowest since August last year (4.5%).

Retail sales grew only 3.4%, the weakest since last November (3.0%), missing both forecasts (3.8%) and July’s 3.7%. Analysts attributed the slowdown to seasonal factors such as floods and heatwaves, alongside weaker domestic and external demand. Indeed, August exports and imports in dollar terms rose 4.4% and 1.3% year-on-year respectively, sharply down from July’s 7.2% and 4.1%.

Fixed asset investment between January and August edged up just 0.5% year-on-year, well below the 1.5% forecast and the 1.6% gain in the January–July period. The cumulative growth rate has decelerated markedly, from 4.2% in March to 3.7% in May, 2.8% in June, 1.6% in July, and now close to zero in August. Analysts noted that restrictions on investment to address overcapacity have further dampened fixed asset growth.

Persistent Deflationary Pressures

Producer price index (PPI) data paints an even bleaker picture. PPI turned negative in October 2022 at -1.3% and has failed to return to positive territory since, extending its decline for 34 consecutive months through July. With deflation entrenched, corporate profitability has deteriorated. Industrial profits fell 2.3% in 2023, after a 3.3% drop the year before. In the first half of this year, cumulative profits were down 1.8% year-on-year, with June alone posting a 4.3% decline — marking three straight years of contraction.

Morgan Stanley warned that deepening deflation could drag China’s H2 growth below 4.5%. Analysts broadly agree that a swift turnaround is unlikely. Instead, tariffs from the United States are expected to depress external demand further in the second half. With weaker export orders, manufacturers will redirect excess supply to the domestic market, exacerbating downward price pressures. UBS forecast that if leading export indicators weaken and tariff headwinds mount, China’s H2 exports to the U.S. could plunge 24% year-on-year, aggravating deflation risks.

Reuters noted, “Disappointing data has left economists divided on whether policymakers will need to roll out more short-term fiscal support to achieve the annual growth target of around 5%.” Within China, consensus is growing that fresh stimulus is only a matter of time should H2 growth fall short of expectations. Ming Daoyu, researcher at Donghai Securities, observed, “From a policy perspective, both the National People’s Congress and the Politburo meeting emphasized more proactive fiscal measures and moderately accommodative monetary policy. If external shocks persist and domestic demand continues to weaken, further stimulus is likely in late Q3 and Q4.”