Goldman Sachs: PBOC Comfortable with Orderly RMB Appreciation; Weak Credit Drives Bond Rally

Overview

Published by Goldman Sachs, this report tracks the latest developments in China's FX and interest rate markets, identifying key indicators including valuation, policy stance, technicals, fund flows, and fundamentals. The core conclusion is that despite April data missing expectations and sparking speculation of further policy easing, the bar for comprehensive easing remains high. On the FX front, the PBOC appears comfortable with an orderly, gradual appreciation of the RMB against the USD, with the USD/CNY spot rate expected to reach 6.50 over the next 12 months. On rates, the recent rally in China Government Bonds (CGB) and decline in Interest Rate Swaps (IRS) have puzzled investors; the report argues this stems not from rate cut expectations but from asset allocation pressures caused by weak credit demand and limited domestic investable assets, forcing banks to increase bond allocations and thereby compressing yields.

Core views

FX Dimension: Policy Anchors Orderly RMB Appreciation. Despite a stronger USD triggered by the March Middle East energy shock, USD/CNY only partially retraced gains and stabilized near 6.90 before breaking below 6.80 in late May. The report suggests the PBOC accepts an annualized appreciation pace of approx. 4%, sufficient to offset carry costs for foreign investors while keeping drag on export competitiveness and inflation within manageable limits. As appreciation expectations become one-sided, exporters' willingness to settle FX has strengthened; it is estimated that since last December, exporters have converted ~$150bn more in FX receipts than normal, helping absorb the excess corporate USD hoarding previously estimated to have peaked at ~$500bn in mid-2025. This makes RMB appreciation more volatile and event-driven. Rates Dimension: Liquidity Anchor and Asset Shortage Drive Low Rates. Recently, 10-year CGB yields fell to ~1.70%, while model-implied fair value rose above 2% (mainly reflecting higher 1-year CPI inflation expectations). Front-end rates also appear hard to explain, with 1-year IRS only 3bps above the 1.4% OMO policy rate, and 1-year CGB yields as low as ~1.15%. The report identifies the missing factor as asset allocation pressure stemming from weak credit demand and limited domestic alternative investment assets. Soft loan demand leaves banks with more balance sheet capacity for bond investment. Unlike previous warnings about funds idling within the financial system, the PBOC explicitly stated in its Q1 Monetary Policy Report that bank bond investment, like credit extension, is a vital channel for financing the real economy and creating money. Meanwhile, limited scope for domestic institutions to increase overseas investment concentrates demand on domestic fixed-income assets. These flows can push CGB yields below model-implied fair value even without policy rate cuts. Policy Outlook: High Bar for Broad Easing; Watch Repo Rates. Weak April data may bring Q2 YoY GDP growth close to the lower bound of the 4.5-5% target range, but this does not signal a sudden deterioration in underlying growth trends. Some weakness reflects seasonal or policy-related factors, such as slower fiscal spending after a strong start to the year, and drags on retail sales from fading trade-in subsidies for consumer goods and increased purchase taxes on EVs. Furthermore, oil-led reflation complicates broad monetary easing; if oil prices stabilize, PPI inflation may peak in late Q2, but uncertainty regarding the reopening of the Strait of Hormuz keeps imported inflation risks elevated. Consequently, policy rate cuts appear difficult to achieve. Monetary policy is more likely to support fiscal implementation through low-profile easing measures, such as maintaining ample interbank liquidity (repo rates below the OMO target) and targeted credit easing (including more relending at lower rates). Only a sharp export slowdown or sustained deterioration in domestic demand would trigger a broader policy response. For the rates market, unless the PBOC is willing to repeat the 2020/2022 move of pushing repo rates above the OMO target, there is limited room for a sustained sell-off, which currently presents a high hurdle.

Analysis framework

The report employs a dual perspective of 'Policy Anchor' and 'Liquidity/Asset Allocation Anchor' for analysis. In FX analysis, the firm looks beyond traditional interest rate differentials and trade fundamentals, focusing instead on interpreting PBOC policy signals (e.g., fixing setting, verbal guidance) and microstructural changes (e.g., exporter settlement behavior, reversal of corporate USD hoarding cycles) to assess the sustainability of exchange rate movements. In rates analysis, the firm compares 'model-implied fair value' with actual market prices to identify deviations of current yields from fundamentals. Furthermore, by dissecting bank balance sheet asset allocation behavior (credit vs. bonds) and the shift in PBOC attitude toward bank bond buying (from warning against idling to recognizing its financing function), it explains why yields continue to decline absent explicit rate cuts. This analytical approach emphasizes the direct impact of internal financial system fund flows and regulatory attitudes on asset prices, rather than relying solely on aggregate macro indicators.

Methodology notes

• Fixed Income & Credit AnalysisSpread analysis

  Model-Implied Fair Value vs. Actual Yield Comparison

  The report constructs models to calculate the theoretical fair value of government bonds (primarily based on fundamentals like inflation expectations) and compares them with actual trading yields. When actual yields are significantly below model values, it indicates pricing forces driven by non-fundamental factors (such as asset allocation pressure in this report), serving as a key method to identify distortions in the bond market.

• Macroeconomic framework

  Bank Balance Sheet Asset Allocation Transmission Mechanism

  The report analyzes how banks allocate surplus funds to the bond market when credit demand is weak, and how shifts in PBOC attitude affect this transmission path. This demonstrates how macro policy influences asset prices through the balance sheet behavior of micro-financial institutions, providing key logic for understanding rate trends amid an 'asset shortage.'

• Event Arbitrage & Behavioral Finance

  Corporate FX Hoarding Cycle and Settlement Behavior Analysis

  The report estimates excess corporate USD hoarding volumes (e.g., $500bn peak) and subsequent settlement flows (e.g., $150bn additional settlement) to gauge supply-demand pressure changes in the FX market. This method combines macro FX analysis with micro corporate financial behavior to more precisely capture short-term drivers of exchange rate volatility.

Key data

• 12-Month USD/CNY Forecast6.50Report forecasts spot rate to reach this level within 12 months, accompanied by near-term overshooting risks
• Annualized RMB Appreciation Pace~4%Appreciation rhythm PBOC appears comfortable with; sufficient to offset foreign carry costs but limiting drag on exports
• Additional Exporter FX Settlement~$150bnAmount settled above normal levels since last December, absorbing previously accumulated USD hoarding
• Peak Excess Corporate USD Hoarding~$500bnPreviously estimated by the report to have peaked in mid-2025
• 10-Year CGB Yield~1.70%Current actual trading level, below model-implied fair value
• 10-Year CGB Model-Implied Fair Value>2%Primarily reflects higher 1-year CPI inflation expectations
• 1-Year IRS Rate~1.43%Only 3bps above the 1.4% OMO policy rate
• 1-Year CGB Yield~1.15%Significantly below policy rate, indicating anomalous front-end pricing
• Q2 YoY GDP Growth ExpectationNear lower bound of 4.5-5% target rangeImpacted by weak April data but does not represent sudden deterioration in underlying growth trend

Impact & implications

The report posits that orderly RMB appreciation and domestically low interest rates will be dominant features in the medium term. For investors, this implies FX market volatility will be driven more by policy signals (e.g., fixing adjustments) and micro fund flows (e.g., exporter settlement pace) than purely by economic fundamental differentials. In the bond market, as long as weak credit demand and domestic asset shortages persist, CGB yields have room to decline further even without explicit PBOC policy rate cuts. However, caution is warranted regarding pullback risks at end-June due to quarter-end liquidity needs and market sensitivity to OMO operations. If Middle East geopolitics sustain high imported inflation, it could constrain the PBOC's room for further easing, thereby pressuring the bond market.

Risks

• Middle East geopolitical uncertainty (e.g., Strait of Hormuz reopening issues) elevates imported inflation risks, hindering monetary easing.
• Sharp export slowdown or sustained deterioration in domestic demand could trigger broader and unpredictable policy responses.
• Increased quarter-end liquidity demand at end-June could cause a pullback in the rates market.
• Unexpected PBOC liquidity tightening, such as repeating the 2020/2022 move of pushing repo rates above the OMO target.
• Unexpected strengthening of the USD index, reducing downside pressure on USD/CNY in the short term.

What to watch

• Re-acceleration of government bond issuance and progress in additional support via policy financial instruments.
• Whether PPI inflation peaks in late Q2 and oil price stability.
• Frequency and scale of PBOC Open Market Operations (OMO), particularly marginal attitude toward liquidity.
• Sustainability of exporter settlement behavior and its impact on RMB central parity setting.
• Spread changes between interbank repo rates and OMO policy rates as an indicator of liquidity tightness.