The economic landscape of 2023 shows a marked improvement compared to the tumultuous events of 2022. Analysts are projecting a stability in the central bank’s policy rates, suggesting that there is little likelihood of adjustment any time soonIt’s conceivable that the yield on 10-year government bonds could taper down to around 2.60%, signaling a potential continuation of favorable economic conditions.
Since mid-April, the Chinese bond market has witnessed a substantial bull runFor instance, the yield on the 10-year government bonds dropped impressively from 2.84% on April 17 to a record low of 2.69% by May 11—the lowest point recorded since November 10, 2022. However, following this exhilarating spike, the bond market entered a phase of fluctuation, with yields stabilizing within a narrow band of 2.69% to 2.72%.
Looking ahead, the current trajectory indicates that the economic resurgence of 2023 outstrips that of 2022. As a result, the central bank is unlikely to modify its policy ratesThe expectation is that the yield on the 10-year government bonds will remain stubbornly resistant to surpassing the record low of 2.48% established during the first cycle in 2020, settling instead toward the 2.60% mark.
Several factors have contributed to this bullish trend in the bond market.
Firstly, there has been a visible slowdown in economic momentum as of AprilThe National Bureau of Statistics reported disappointing figures for April’s PMI, along with subpar data on consumption, investment, and industrial productionReal estate investments sustained a considerable year-on-year decline of 6.2% from January through AprilAdditionally, property sales have taken a hit, with average daily sales in 30 major cities falling to 399,000 square meters in May—an alarming drop from 426,000 square meters in April and 536,000 square meters in March, reverting to levels last observed in November 2022. This deterioration of fundamental economic metrics is indirectly bolstering the bond market.
Moreover, there has been a coordinated reduction in deposit rates across various banks
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Following the trend initiated by major state-owned banks, smaller banks have started lowering their deposit rates since April 2023. By May 5, institutions like Bohai Bank and Zhejiang Commercial Bank joined this initiative, with reductions typically ranging from 4 to 30 basis pointsFor example, the 3-year and 5-year fixed-term deposit rates have fallen to between 2.90% and 2.95%, both dipping below the 3% thresholdWith these decreases, we observe a direct correlation to the banks’ significantly lowered costs for liabilities, influencing their required returns on asset investmentsAs this translates to modest lending rates, institutions are now increasingly inclined toward bond investments, further contributing to declining yields.
Additionally, a rather loose liquidity atmosphere has been observed, which has encouraged leveraged buying within the debt marketsFor instance, the average R007 rate plummeted by 20 basis points from March to April, hitting 2.30%. The trend continued, with values dropping further to 1.97% by May 26. The R007 showed a more pronounced decline than its DR007 counterpart, which fluctuated but eventually fell to a record low of 1.82% in MayThis indicates that non-banking financial entities are flush with liquidity, driven by a robust appetite for investmentNotably, the volume of pledged repos has surged, with daily transactions frequently exceeding 7 trillion yuan since mid-April and peaking at a staggering 8.2 trillion yuan by May 24. The dominance of overnight repurchase transactions, which have made up over 90% of total deals in May, underscores the reliance on leverage to fuel bond purchases, further stoking the bullish sentiment.
An historical context helps to deepen our understanding of these trends.
As of May 26, the benchmark 10-year government bond yield stood at 2.72%, placing it within the fifth percentile of historical yields, a relatively low position
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Analyzing the historical cycles reveals that since the onset of the pandemic in 2020, Chinese bond yields have experienced three significant downtrendsThe current cycle began its downward march in late February 2023 and gathered momentum in mid-April—marking it as the third downtrend, which can be appropriately mapped against the prior cycles for forecasting.
The first downtrend hit its nadir on April 8, 2020, when the 10-year bond yield plunged to 2.48%, the lowest since June 24, 2002. This was predominantly spurred by the central bank's aggressive and unexpected monetary easing during the pandemic, which included targeted reductions for small and medium-sized banks, as well as critical cuts to reverse repo and MLF operation rates.
The second critical low emerged on August 18, 2022, where yields hit 2.58%, primarily due to a surprise rate cut by the central bankAdditionally, the resurgence of COVID-19 posed challenges to economic optimism and amplified pessimistic expectations—propelling the 10-year bond yield to a fresh low since May 6, 2020.
In summary, the lows of the bond yield cycles have closely mirrored instances of excessive monetary policy easing by the central bank, dovetailing with robust liquidity within the interbank marketsDuring episodes when yields hit their respective cycle lows, DR007 rates were notably low—indicating very favorable conditions for institutional demandJust as observed during the first two key cycle lows, which recorded DR007 rates at 1.28% and 1.42%, both corresponded to historical low percentiles in the financial landscapeIt is also interesting to note that reversals in liquidity often foresee movements in government bond yields by a few weeks to a month.
Forecasting the bond market's trajectory yields several implications.
In the near term, we may anticipate fluctuations in long-term bonds while short-term bonds may fare better
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