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Good morning. GameStop rose 31 per cent on Tuesday. We don’t know why; it does not appear to have been a short squeeze or a gamma squeeze. It may be just that everything is stupid now. Got a better theory? Email us: and

Investing in the uninvestable

Last week Rob aired the case that Chinese equities might be uninvestable for international investors. High-yield Chinese credit doesn’t look much better:

Line chart of Risky dollar bonds issued by Chinese firms are crashing showing Freefall

The main story is the same as ever: the crackup in Chinese property. “Everything else around that is noise, or amplification,” noted Paul Lukaszewski, Abrdn’s Asia credit head. He said that includes China’s Omicron wave, the US threat to delist Chinese companies, and potential collateral damage from Ukraine sanctions.

Asked for a broad snapshot of the property market, Lukaszewski sounded dire:

Chinese single-B spreads are at about 6,500 basis points over Treasuries, reflecting the stress in the property sector. Including distressed exchanges, the default rate for Chinese property developers is now approaching 50 per cent.

Contagion is still spreading given the lack of a sufficient policy response. And importantly, consumer behaviour is clearly changing. You’re seeing 7-8 per cent declines in average home sales prices, on top of 40-50 per cent drops in monthly contracted sales, and our analysis shows buyers are differentiating between developers seen as safer or riskier.

Furthermore, land sales are down anywhere between 20-60 per cent, completions are -10 per cent and new starts are -15 per cent. And this weakness is before Covid mobility restrictions started to bite in March.

Though the situation is intensifying, the core dynamics haven’t changed. To recap:

  • Credit-fuelled homebuilding has long been crucial to China’s output growth

  • In late 2020, Beijing imposed leverage ratios on property developers and lending restrictions on banks (sets of “red lines”)

  • The debt limits and subsequent slowing property sales have created widespread liquidity shortages, fuelling a wave of property developer defaults

The government is in a “race against time”, said Logan Wright of Rhodium Group. It could ease up on its red lines, but such a reversal would be politically humiliating. Lukaszewski thinks the most effective option is a “liquidity bazooka” — an overt display of support to developers that could restore confidence. Yet that, too, risks political blowback.

Dealing directly in China’s property sector looks stupid for anyone but the boldest distressed-debt investors (such as Oaktree Capital). On Tuesday Evergrande revealed that someone, probably a Chinese bank, had seized $2bn of its cash. Everything now depends on legal tussling and politics.

But if you’ve got the stomach for unquantifiable political risk, there may be value elsewhere, driven by loosening policy. Here’s JPMorgan on Chinese risk assets on Monday:

On China, we continue to be bullish given the broad policy pivot that has occurred . . . an ambitious target for GDP growth of 5.5 per cent makes the pivot all the more necessary, especially given the risks of geopolitical tensions and spillovers as well the impact of Covid lockdowns . . . we think Chinese risk assets will benefit from the policy pivot coming in many forms: lower policy rates, higher [total social financing] growth, [required reserves ratio] cuts, lower mortgage rates and down payment amounts for property, eliminating quantitative targets for decarbonisation, etc.

In other words, the government is facing multiple crises and will deal with them by easing policy, so buy risk assets while they are cheap. The deep links between real estate investment and output mean China’s high-growth target is probably impossible without direct support for property. In 2014 a cooling housing market pushed the government to launch a slum redevelopment campaign, noted Nicholas Borst of Seafarer Capital Partners. A collapsing one might prompt an even stronger response.

Or take a related trade — Chinese sovereign bonds. One bull argument goes like this:

  • The US and Europe are increasing rates

  • China will probably have to cut rates further, pushing up bond prices

  • China’s economy is big enough to diverge from rising US rates, so you get diversification away from Treasuries too

The usual pitfall here would be that China slashing rates as the US raises them would push capital toward the higher-yielding environment. But Lin Li, who heads up Asia markets research at MUFG, pointed out that the real interest spread is still positive for China, thanks to roaring inflation in America.

These trades are very risky. Any international investor buying China now is necessarily betting on Beijing’s politics. But given the country’s growth record and dirt-cheap valuations, it makes sense that some want to try their hand. (Ethan Wu)

(Warning: geek level high.)

Yesterday’s letter blithely assumed that inverted yield curves signals impending recessions, rather than causing them. More than one reader argued there is a causal link, as well, which runs through credit providers’ profitability.

The argument is simple. Banks and other lenders fund themselves at short-term rates, most often through deposits, and lend out the money at long-term rates. The spread between short and long rates is therefore the profit margin on lending. An inverted yield curve means short rates are above long ones, so lending becomes uneconomic, banks lend less, businesses have less capital, and the economy contracts.

The insightful Policy Tensor sent along a 2010 New York Fed paper by Tobias Adrain, Arturo Estrella and Hyun Song Shin that makes this argument empirically. Here’s how the authors characterised the theory I had assumed:

The traditional explanation offered for the forecasting power of the term spread rests on the informational value of the yield curve for future short rates. An inverted yield curve is seen as reflecting expectations of low future short rates which, in turn, are attributed to weakness in expected credit demand, diminished inflation expectations, and central bank policy in response to subdued economic conditions.

And here is their summary of the causal theory:

The compression of the term spread [ie flattening or inversion of the yield curve] may mean that the marginal loan becomes uneconomic . . . There will, therefore, be an impact on the supply of credit to the economy . . . the reduced supply of credit also has an amplifying effect due to the widening of the risk premiums demanded by the intermediaries, putting a further downward spiral on real activity.

The authors did a multivariable regression analysis of GDP growth, the 10 year/3 month curve, commercial banks net interest margins, and the asset levels of financial intermediaries (including “shadow banks”), short rates, and market volatility, all from 1990 to 2008, to test this causal account. For you stats nerds, here are the regression coefficients of the variables, with the inferred direction of causality added in my red scrawl:

Chart of the analysis

All makes perfectly good sense to a simple journalist like me, though I suppose you could quibble about the p-values of some of those correlations.

At the current moment, however, the crucial point is that financial intermediation has changed a huge amount since 2008, where the paper’s data end. Bank profits used to mostly go up when short rates fell; now they mostly go down.

The key difference is that deposit funding was less plentiful and more expensive before the financial crisis. To simplify massively, post-crisis banks all but stopped funding themselves in the short-term debt markets (because that had turned out to be a super stupid thing to do), lower rates made deposit funding much cheaper and more plentiful, and banks held a lot more capital generally. The result is that banks’ deposit costs are much lower and less sensitive to moves in short rates now, even as their returns from lending (which are mostly prices at the short rate plus a fixed spread) remain sensitive to them.

An anecdotal example. Banks are required to include their sensitivity to different points on the yield curve in their regulatory filings. Here is Bank of America’s disclosure from 2007:

Bank of America’s disclosure from 2007

This will be a little confusing if you are not a former banking reporter like myself. For simplicity, look at the line labelled “Steepeners — Short end” (circled in red). That line means “here is how much our lending profits will change given a 100 basis point fall in the short rate” (steepening the curve by dropping the short end). As you can see, for 2007, the bank estimated it would mean an addition $1.3bn in profit. The reason: because their deposits costs would fall more than their loan prices.

Now look at the same BofA disclosure from last year. Look at the short steepener line again (again, what happens when short rates fall). Ignore the magnitude of the number — the bank is much bigger now. It’s the sign that matters, and it has reversed:

Bank of America’s disclosure from last year

Now a fall in short rates means lending profits go down, because deposits funding is already virtually free and can’t get much cheaper, but all those loans pegged to short rates go down in price.

In short, higher short rates were once bad for bank profits, and now they are good. As one of my favourite bank analysts, Brian Foran of Autonomous, summed it up in an email:

It is crazy. When I started my career the good net interest margin scenario for BofA and other banks was Fed cutting rates! — Eg the short end steepener scenario. Times have changed. All goes back to the deposits point — loan/deposit ratio is 60 per cent for the industry today versus 97 per cent in 2007

Lower long rates (“long end flatteners”) were bad for banks in 2007, and they are still bad. Some types of lending such as mortgages do depend on long rates, and banks own a lot of Treasuries. But the short end is what is most important now: the average bank’s rate sensitivity is weighted two-thirds to the short end, Foran estimates.

So a flat yield curve hurts banks’ margins a lot less than when Adrain, Estrella and Shin wrote. But that’s not the whole story. Banks have been steadily losing market share in lending to non-banks, in the form of the bond market, private equity firms, business development companies, and the like. How sensitive are those non-banks profits to an inverted curve? I’m not really sure. I will work on it and report back.

One good read

If any of Ethan’s recent segments read worse than usual, blame Elden Ring, the masochistically difficult new game by FromSoftware. Tom Faber writes in his excellent FT review that the game is a flawed, inscrutable masterpiece.

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