China Crisis Gauge Hits Record High Amid Flight To Quality

There is a big flight to quality, warns one trader as the spread between interest rate swaps (implicitly bank risk) and government bonds soared to a record high. This crisis gauge flashing red is also followed by 3 month SHIBOR (short-dated interbank lending rates) surging to an 8-month high. China’s CDS have jumped 30bps since the Fed taper and as Bloomberg reports that billionaire investors like George Soros and Bill Gross have drawn uncomfortable parallels between the situation in China now and the US before 2008 (when this crisis gauge was key in spotting the carnage to come). Simply put, the banks don’t trust each other.

“What I do see are increasing parallels between China and the U.S. in the run-up to the global financial crisis ,” said Patrick Perret-Green, a London-based strategist at Australia & New Zealand Banking Group Ltd. “Shibor-repo is similar to Libor-OIS. Shadow banking is subprime. Credit spreads are widening as they did in 2007. Money growth is softening as tightening bites .”

“There is a big flight to quality,” said Wee-Khoon Chong, Singapore-based head of rates strategy Asia ex-Japan at Nomura. “In times of stress, you sell credits, sell longer-dated bonds into shorter ones and you are going to the government bond market. If the default situation gets out of control, yields are going to fall a lot.”

The slowdown may fuel bank bad loans, which surged 28.5 billion yuan in the final quarter of 2013 to 592 billion yuan, the highest since September 2008, according to China Banking Regulatory Commission data.

Add to that the seemingly intentional devaluation of the Yuan and risk-asset-based carry traders have a problem, as we explained previously.

As the Fed tapers, and the size of its balance sheet stabilizes/contracts, we should expect this sequence to reverse. Confidence is a fragile membrane. Not only does the Fed’s balance sheet matter as a source of funds, but we believe so does the attractiveness of the recipient of the carry trade – and the trust in its collateral.

What makes sense for an individual carry trade — borrow low, invest at higher rates — falls prey to the fallacy of composition, when too many engage in the same carry trade. And eventually question the underlying collateral, now huge, and potentially suspect. China is a case in point. If our colleagues David Cui and Bin Gao are right, the trust sector in China could create rollover risks that reverse a gluttonous carry trade within China, but partly financed overseas .