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Why buying China bonds and stocks is looking dicey

China's markets, long considered insulated from global ructions due to strict capital controls, took a hit this week from the U.S. rate hike.

Despite the mainland's capital controls, its bond market joined the global market ructions on Thursday after the U.S. Federal Reserve surprised by saying it expected to hike interest rates three times next year, rather than the previously forecast two hikes. The Fed also hiked its benchmark rate by 25 basis points, as was widely expected, to a target range of 0.5 to 0.75 percent, only its second rate hike in a decade.

Analysts expected the bond yields were only headed even higher, despite the controls.

"The capital controls make China's financial markets the least exposed [in Asia] to selling pressure emanating from the U.S. Treasury market, but they're not completely closed off," noted Tim Condon, head of research for Asia at ING.

He expected that a combination of the recent drop in China's currency against the dollar, overall liquidity tightness and the mainland's stronger economic data would send bond yields higher.

China's bond yields climbed, with the benchmark 10-year yield rising as high as 3.346 percent on Friday from 3.233 percent on Thursday. That's up from levels just below 3 percent at the beginning of December. Bond yields move inversely to prices.

Trade in futures for the five-year and 10-year bonds were reportedly halted twice on Thursday – once in the morning session and again in the afternoon – after they fell far enough to breach the 2 percent trading limit.

"I don't think the worst is behind. Yields are going higher," Condon said. "The 10-year has been trading below 3 percent for much of this year. We will look back on that as a deflation trade in same lines as negative yields in Germany and Japan were deflation trades."

Inflation expectations have picked up globally, especially as the U.S. was expected to engage in more fiscal spending. China's producer price index jumped 3.3 percent on-year in November, the fastest pace in five years, while the consumer price index rose 2.3 percent on-year.

Others also expected China's bond yields to rise.

Frances Cheung, head of rates strategy for Asia ex-Japan at Societe Generale, said on Friday that the market was "quite bearish."

Men look an electronic board showing stock information at a brokerage house in Beijing, China, January 5, 2016.
Kim Kyung-Hoon | Reuters
Men look an electronic board showing stock information at a brokerage house in Beijing, China, January 5, 2016.

While she expected that bond yields might not fall too much near term as managers would need to allocate some funds to cash bonds, swaps and futures would likely remain under pressure.

"On a multi-month horizon, cash bonds will play catch up and yields will rise," she said.

But not everyone expected higher China bond yields were here to stay.

Julian Evans-Pritchard, a China economist at Capital Economics, said on Friday that he was sceptical that China's inflation would pick up much from here as the rise in producer prices was due to a rebound in commodity prices, which may not be sustainable.

"I'm sceptical that the People's Bank will really tighten conditions as much as people are expecting," he said. "The bond rout looks like it's gone a bit too far for me."

Analysts pointed to a multiple reasons for the selloff in China's bond market. For one, the stronger dollar has weighed on China's yuan as higher U.S. interest rates spur outflows from the currency. On Friday, the PBOC set the yuan's midpoint at 6.9508, the Chinese currency's lowest level in eight-and-a-half years; China's central bank lets the yuan spot rate rise or fall a maximum of 2 percent against the dollar relative to the official fixing rate.

Additionally, liquidity had tightened on the mainland; Reuters reported, citing financial magazine Caixin, which reported that the PBOC stepped in on Thursday to urge commercial banks, which had turned cautious, to lend to non-bank financial companies.

At the same time, regulators on the mainland told banks to stop extending financial support to companies breaching the government's capacity reduction plans, Reuters reported.

Some noted that the bond market turmoil could spill over to China's stock markets.

"Some hybrid funds may consider selling their stock investments for fund redemption due to weak liquidity for their bond investments following the bond market and money market crash," analysts at Credit Suisse said in a note dated Friday. It noted that the hybrid mutual fund market size was around 1.9 trillion yuan ($273.5 billion), with around 10 percent of that invested in the stock market.

It expected that companies with high financial leverage and refinancing demand would take a hit, tipping five stocks as especially vulnerable: China Eastern Airlines, China Southern Airlines, Yanzhou Coal, Huadian Power and Huaneng Power.

But it noted that insurers would likely benefit, in part as they will get higher yields on reinvesting funds. Banks were also likely to benefit as effective loan rates would generally increase, it said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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