ZheShang TanHan: Review and Reflection on the 30-year Treasury Bond Yield Breaking 2.5%

Four-point logic of "short-term bullish, high configuration"

Logic One: Although the central bank objectively has concerns about the risks of long-term bonds, 1) before the implementation of the actual yield curve control mechanism, the market behavior lacks effective constraints; 2) the probability of maintaining loose monetary policy tools at the end of the quarter is high; 3) the bond market lacks fundamental and supply-side pressure resonance, and the impact of a single bearish factor on the bond market will gradually weaken.

Logic Two: The "interest rate reduction tide" brought about by rectifying manual interest payments and deposit rates brings dual benefits—1) banks shrinking their balance sheets drive financial data "dehydration," weakening market-wide credit expectations; 2) banks transferring funds to the non-banking system, where the risk appetite is higher, driving long-term interest rates further down.

Logic Three: Some funds have the attribute of "bearish bullishness," and the natural coupon value of bonds gives the market motivation to hold in a sideways adjustment situation, with some funds adopting a wait-and-see attitude and weaker selling intentions.

Logic Four: The market's focus on curve strategies is increasing, but the cost-effectiveness of various maturity points on the curve is constantly adjusting dynamically, with active and inactive maturity rates likely to continue to decline in a "step-by-step" manner.

"The central bank, institutions, and the bond market" cannot form a triangle

The current market background is: (1) the fundamentals are still in the process of repair, with a demand for monetary policy support and consolidation of the economic recovery trend, leaning towards loose policy; (2) the scarcity of non-bank assets combined with the coupon value of bonds naturally motivates institutions to buy bonds; (3) the central bank is concerned about the risk of long-term bond rates, wanting to maintain rate stability while guarding against the risk of a bond market oversold negative feedback loop.

However, with factors such as fundamentals and supply-side remaining relatively stable, the actions of the central bank, market-oriented institutions, and the bond market are likely to form an impossible triangle: ① Loose monetary policy + institutional buying → Rate decline; ② Loose monetary policy + stable rates → Institutions lack profit-making intentions; ③ Institutional buying + stable rates → Difficult to maintain loose monetary policy. Under this impossible triangle scenario, if there is an adjustment in interest rates, there will likely be significant constraints from fundamentals, monetary policy, and supply-side, with a low probability of short-term occurrences.

Main Text

Reflecting on the 30-year bond rate breaking 2.5%

Since the end of April, we have maintained the view of "shock adjustment, insufficient odds" for the trend of the 30-year bond rate, and the subsequent rate trend has basically met expectations; but recently, long-term bonds have shown significant strength, with the 30-year bond rate breaking 2.49% intraday on June 18th. The most direct trigger for the rate decline that day was another intensive "interest rate reduction tide" by small and medium-sized banks, prompting us to rethink the subsequent market trends and bond market main logic.

Our judgment: In the short term, on a monthly basis, long-term and ultra-long-term rates have a strong inertia to break downwards; in the medium term, on a quarterly basis, the long end still faces constraints of insufficient odds for downward movement, but adjustments require the opportunity for multiple bearish resonances. Our judgment on the background of "asset shortage" has always remained unchanged, but a rethinking of four logical points suggests adopting a "short-term bullish on long-term interest rates, buy on high" approach when dealing with short-term market changes.

Logic One: Although the central bank's concerns about long-term bond risks objectively exist, 1) before the implementation of the actual yield curve control mechanism, market behavior lacks effective constraints; 2) the probability of maintaining loose conventional monetary policy tools at the end of the quarter is high; 3) the bond market lacks resonance from fundamental and supply-side pressures, and the impact of a single negative factor on the bond market will gradually dull.

Previously, the central bank and related media have repeatedly warned of long-term bond risks, but the market's sensitivity to the warning mode has gradually dulled. Comparing the adjustment magnitude of 30-year government bonds on April 24 and May 31, it has changed from a pricing of 5.8 basis points to 2.25 basis points.

On June 19, PBOC Governor Pan Gongsheng mentioned at the Lujiazui Forum that the buying and selling of government bonds will be included in monetary policy tools, while also pointing out the risk of duration mismatch caused by non-bank institutions holding long-term bonds, but substantial operations are not expected to be implemented quickly.

1. Government bond trading: "Gradually include the trading of secondary market government bonds in the monetary policy toolbox," "position it as a basic currency injection channel and liquidity management tool, with both buying and selling, combined with other tools to create a suitable liquidity environment"; 2) Non-bank duration mismatch risk: "Focus on the duration mismatch and interest rate risk of some non-bank entities holding a large amount of medium- to long-term bonds, maintaining a normal upward sloping yield curve"; 3) Implementation pace: "The People's Bank of China is strengthening communication with the Ministry of Finance to jointly study and promote implementation, this process is overall progressive," indicating that the unconventional monetary policy tool of short-term buying and selling of government bonds will not be implemented quickly, and the substantial short-term impact is expected to be limited.

From the Financial Times article on June 14 highlighting the need to pay attention to "changes in the net asset value of bank wealth management products, public funds, and other asset management products," to Governor Pan's mention of "non-bank duration mismatch risk" on June 19, it can be inferred that the central bank's concerns about long-term bond risks have extended from the banking system to the non-banking system. However, the current ample liquidity in the non-banking system is an objective fact, and in the context where monetary policy is difficult to change this situation, regulatory policies may be able to effectively promote non-banks to reduce their long-term asset positions.

Compared to the "financial deleveraging" period in 2017, monetary policy tightening and strengthened financial regulation worked together to achieve the goal of reducing leverage in the financial sector. On one hand, at the monetary policy level, funds were withdrawn, short-term funds were locked, the MLF and open market operation rates were raised multiple times, effectively increasing the financing costs of financial institutions, and breaking the foundation for institutions to leverage.

On the other hand, macro-prudential and micro-prudential measures were combined to strengthen supervision from the institutional behavior level, such as the establishment of the MPA assessment system by the central bank in 2016, the inclusion of off-balance sheet wealth management products in the broad credit range in 2017, effectively controlling the disorderly expansion of small and medium-sized banks' balance sheets, and the CBIRC also optimized the asset penetration disclosure requirements for off-balance sheet wealth management products in 2017 Therefore, the "financial deleveraging" process in 2017 had clear coordination at the monetary policy and financial regulatory levels.

However, looking back at the recent central bank's warning about the risks of long-term bond yields, both conventional monetary policy and financial regulation are not comparable to 2017. This basically sets the tone for either oscillation or slight adjustment in long-term interest rates, with a relatively small possibility of major adjustments occurring.

On one hand, there are currently no clear restrictions on banks and non-banks investing in long-term bonds; on the other hand, apart from advancing the implementation of trading government bonds, other conventional monetary policy tools currently do not have the fundamental basis for tightening and the basis for bank liquidity. As mentioned by Pan Gongsheng at the Lujiazui Forum, the monetary policy is expected to continue to maintain a supportive stance, strengthen countercyclical and cross-cycle adjustments, and support the consolidation and enhancement of the positive economic recovery trend. Therefore, the monetary policy is expected to remain relatively loose in stance and tone.

Therefore, if there is a significant adjustment in the bond market in the future, it will require factors such as fundamental repair beyond expectations or a significant increase in bond supply pressure to cooperate. Therefore, in terms of timing, the potential concerns of "accelerating fiscal efforts and implementing yield curve control mechanisms" in the third quarter may cause pressure for a phase adjustment in interest rates.

Logic Two: The wave of "interest rate cuts" in manual interest adjustments and deposit rates brings dual benefits—1) Banks shrinking their balance sheets leading to "dehydration" of financial data, weakening market-wide credit expectations; 2) Funds transferring from banks to the non-bank system, where the risk appetite is higher, driving long-term interest rates further down.

On one hand, M1 and short-term corporate loans represent corporate operating intentions and activity levels. Although manual interest adjustments do not weaken the fundamentals, they still have an impact on the market's broad credit expectations.

On the other hand, as the impact of manual interest adjustments mainly affects corporate demand deposits, these funds are more likely to flow from banks to wealth management products. The "interest rate cut" wave includes a general decrease in both demand and time deposit rates, which also allows funds such as funds and insurance companies to generate returns. These non-bank institutions have longer durations, higher absolute return demands and pressures, and higher risk appetite. Therefore, the demand for trading and allocating long-term interest rates is stronger.

Logic Three: Some funds have a "bearish bullish" attribute, where the inherent coupon value of bonds gives the market motivation to hold in a sideways adjustment situation, and some funds with a wait-and-see attitude have weaker selling intentions.

Since April, some institutions have exhibited a "bearish bullish" situation. On one hand, reflected in the data, the total trading volume of government bonds with a maturity of 7 years and above has significantly declined, indicating that some institutions prefer holding strategies over trading strategies in the absence of clear trends, thus showing a tendency towards holding and allocating, leading to a shift in viewpoints but still in a wait-and-see behavior.

On the other hand, bonds have coupon value, providing static income to bond holders, which gives a significant advantage over being short. Institutions with a "bullish bearish" stance are naturally less. Therefore, in a situation where institutional views are inconsistent, this allocation strategy has driven more institutions to "bearish bullish," making it temporarily difficult for interest rate bonds to experience a significant volume decline Logic Four: The market's attention to curve strategies is constantly increasing, but the cost-effectiveness of various tenor points on the curve itself is constantly adjusting dynamically, with active and inactive tenor rates likely to continue to decline in a "left and right foot stepping" manner.

In the previous report "Focus on the Meteor Strategy under the Staircase Curve Pattern," we pointed out the phenomenon of "quiet" rise in inactive bonds in the previous period. In the case of the central bank warning about the risk of long-term bond rates, the market has a high degree of attention to the lower limit of the active bond rate operating range at key points on the curve, while the bottom of the inactive bond rate downward range receives less market attention and has a higher safety margin in the previous period, hence the significant rise in inactive bonds.

However, the staircase pattern is difficult to become a stable long-term pattern. The cost-effectiveness of various tenor points on the curve itself is constantly adjusting dynamically. When the inactive tenor rates have already been significantly reduced, the cost-effectiveness of active tenor varieties will be relatively highlighted again. Active and inactive tenor rates are likely to continue to decline in a "left and right foot stepping" manner.

In summary, we believe that the key to short-term judgment of the bond market trend is to clarify the dynamic relationship between the "central bank, institutions, and bond market."

The current market background is: (1) The fundamentals are still in the process of repair, at this time, monetary policy has the demand to support and consolidate the good recovery of the economy, with a main tone leaning towards loose; (2) Non-bank asset shortage, the relative ranking assessment mechanism superimposed with the coupon value of bonds, institutions naturally have the motivation to long bonds; (3) The central bank is concerned about the risk of long-term bond rates, wanting to maintain rate stability, but also guard against the risk of bond market oversold negative feedback.

However, with factors such as fundamentals and supply-side maintaining basic stability, the actions of the central bank, market-oriented institutions, and bond market trends are likely to form an impossible triangle: ① Monetary easing + institutions long → rate decline; ② Monetary easing + rate stability → institutions have no profit motive; ③ Institutions long + rate stability → monetary policy difficult to maintain loose state. Under this impossible triangle driving force, if rates adjust, then fundamentals, monetary policy, and supply-side are likely to have significant constraints, with small probabilities in the short term.

This article is authored by Zhejiang Securities Tan Han (Practice Certificate Number: S1230523080005), Shen Nieping (Practice Certificate Number: S1230524020005), Source: Tan Han Research Notes, Original Title: "On the Impossible Triangle of the Current Bond Market"