The onshore bond market has experienced substantial correction in the past 2 months, driven by a more prudent stance of the PBOC and rising reflationary expectations. In retrospect, this is the 2nd round of bond market correction of the year. While the sell-off in March-April was triggered by higher growth expectation post Chinese New Year and an increase in credit default events, the more recent correction was driven by a more prudent stance of the PBOC, as well as the rotation of asset allocation away from fixed income products as the reflation progressed further and the investment return in the real economy continued to recover.

In the short term, interbank liquidities may remain tight amid the upcoming year-end MPA and the current monetary policy priority of FX stabilization and financial market deleveraging.

Over the medium term, the pressure for asset allocation to rotate out of fixed income products may persist as we see further upside to inflation and profitability growth in 2017, especially considering the hefty allocation into the bond market since 2014. Fixed income products have enjoyed a 3 year bull-market from 4Q2014-3Q2016. With inflation rising and corporate profitability recovering, we may see continued rotation out of fixed income products and into more “productive assets” such as equities and business activities.

Rising bond market volatility may exert downward pressure on the prices of other assets in the near term, while the small-medium sized banks and selected financial institutions are more vulnerable to continued outflow from bond & money market products. In the interim, timely liquidity support from the central bank holds the key to backstopping the negative feedback loop on market liquidity and preventing over-correction of asset prices.

In our view, however, rising market rates so far will unlikely reverse the ongoing reflationary trajectory, since higher funding cost can be compensated by rising inflation/stronger pricing power of the corporate sector. We have more confidence in the pricing power of the industrial sector this time round compared with the 2013 bond market correction, as the supply for many industrial products have effectively tightened after a 5-6 year deflation and capacity consolidation cycle. On the other hand, consumer products with differentiated quality and higher pricing power will enjoy better profitability in an inflationary environment as well. Therefore, the coordinated sell-down of bonds & equities will unlikely be supported by the medium term fundamentals this time round.