What does the central bank's net purchase of 100 billion yuan in government bonds signify? CICC: Smooth transmission, maintaining steepness

On August 30, the central bank announced that in August, the People's Bank of China conducted open market operations (OMO) for the trading of government bonds, buying short-term government bonds and selling long-term government bonds, with a net purchase of bonds worth 100 billion yuan for the month.

In the short term, the purpose of this operation is to avoid further flattening of the yield curve. During the economic downturn, from a real economy perspective, it is necessary to maintain loose monetary policy. However, on the other hand, rapid decline in long-term interest rates and flattening of the yield curve may increase financial risks. The central bank needs to stabilize growth while also guarding against risks.

In the medium to long term, the central bank's reintroduction of government bond trading in the secondary market into open market operations is a reflection of the new framework transition of monetary policy. In fact, we have always emphasized that in the latter half of the financial cycle, the necessity of loose monetary policy and expansive fiscal policy has significantly increased.

Under the current circumstances, fiscal expansion not only promotes total demand but also raises the equilibrium interest rate level, limiting downward pressure on market interest rates, which is a more effective way to balance growth stabilization and risk prevention.

In the short term, the direct purpose of restarting OMO government bond trading is to prevent the yield curve from further flattening and to strike a balance between stabilizing growth and preventing risks.

► During the financial cycle downturn, a shortage of safe assets leads to a flattening of the yield curve. From the perspective of residents and enterprises, as liquidity preference increases, funds flow more towards government bonds and other safe assets. This year, with the reduction in deposit interest rates and crackdown on informal interest payments, some deposits have moved to wealth management and funds, leading to a significant increase in holdings of long-term government bonds by wealth management and funds. From the perspective of bank proprietary trading and insurance asset management, the relative returns (after deducting taxes and capital costs) of various assets such as long-term government bonds, policy bank bonds, and local government bonds are higher, stable, and safe.

► However, rapid decline in long-term interest rates adds financial risks. 1) Trading volume of long-term government bonds hits a historical high. Since 2023, the trading volume of government bonds has significantly increased (Chart 1), with the 10-year and 30-year bonds reaching new highs (in July, long-term bonds accounted for 34% of the total market value of government bonds).

2) Low risk premium for long-term government bonds. Based on the ACM model, we split the yield of China's 10-year government bonds into risk-free return (the average of expected short-term interest rates in the future) and risk premium (compensation for investors bearing price volatility risk). The results in Chart 2 show that the decline in long-term bond yields since 2023 is mainly due to the decrease in risk premium, which has now dropped to near zero, and there is a possibility of irrational behavior in bond market trading.

3) Duration volatility hits a new high, indicating strong sentiment among some investors for extending duration. Our calculations show the duration of long-term pure bond funds since 2023 as shown in Chart 3, which has been rising since 2023. Although the mean is still far from the historical high point, the standard deviation has hit a historical high.

Chart 1: Trading volume of long-term bonds has significantly increased since the second half of 2023

Source of information: Wind, CICC Research Department

Chart 2: Currently, the risk premium of the 10-year government bond yield is only 0.5%

Source of information: Adrian et al. (2013), CICC Research Department

Chart 3: Currently, the duration standard deviation of medium to long-term pure bond funds is high

► The narrowing of term spreads has become an important factor in compressing the net interest margin of financial institutions. The impact of flattening yield curves on interest margins may exhibit a non-linear trend. Further flattening of the yield curve will further compress the profit space of banks and other financial institutions. According to Borio et al. (2015) [2], research has found a positive correlation between the slope of the yield curve and the net interest margin of banks (interest margin income / total bank assets). At the same time, the slope of the yield curve has a non-linear impact on the net interest margin (Chart 4), the flatter the curve, the greater the impact on the net interest margin of banks. Currently, the net interest margin of banks is low (Chart 5), and life insurance companies also face margin loss risks (Chart 6). In addition to the intermediate target shifting from quantity to price, maintaining the steepness of the curve is also crucial for maintaining the interest margin.

Chart 4: The slope of the yield curve has a non-linear impact on the proportion of net interest income of banks

Source of information: The influence of monetary policy on bank profitability BIS 2015, CICC Research Department; Note: Net interest margin = net interest income / total bank assets Chart 5: Low Net Interest Margin for Banks

Source: Wind, CICC Research Department

Chart 6: Life Insurance May Experience Spread Loss

Source: Wind, CICC Research Department

In the medium to long term, the central bank's reintroduction of government bond trading into the OMO toolbox is a reflection of the transformation of the monetary policy framework. Firstly, open market operations (OMO) buying and selling government bonds is an international practice (OMO includes repos and securities trading).

Secondly, OMO trading of government bonds reflects the shift in the monetary policy framework from quantity to price and the smooth transmission. During the financial downturn, the traditional "broad credit" policy effectiveness weakens, and the monetary policy intermediate target is shifting from quantity to price. The central bank has recently strengthened the policy attributes of the Repo rate by indicating interest rates, adding a soft narrow corridor, and lowering short-term rates. However, it can only control short-term market rates, lacking the ability to control medium to long-term rates and term spreads.

The mission of MLF is gradually being completed (the medium-term financing market is relatively developed), and its policy attributes are fading. With a variety of government bond maturities, including government bond trading can regulate market rates of different maturities, play the benchmark role of government bond rates, and facilitate price transmission from short to long.

As monetary policy loosens, the necessity of expansive fiscal policy significantly increases. In the current situation, fiscal expansion not only promotes total demand but also raises the equilibrium interest rate level, limiting downward pressure on market rates, which is a more effective way to stabilize growth and prevent risks. Monetary easing mainly alleviates debt burdens by lowering interest rates, but rate cuts inevitably lead to narrowing interest margins for financial institutions.

At the same time, in the second half of the financial cycle, the effectiveness of lowering rates to stimulate private sector leverage weakens. Government leverage can help the private sector deleverage, and research by the BIS shows that the extent of private sector balance sheet repair during the financial downturn determines the speed of economic recovery.

Furthermore, "expansive fiscal policy" helps increase the supply of safe assets and alleviate the shortage of safe assets. "Monetary easing + expansive fiscal policy" is more likely to reach the real economy, improve risk appetite, and even bypass interest rate cuts to boost asset returns, more effectively stabilizing growth while guarding against overall financial risks Authors: Huang Wenjing (S0080520080004), Zhang Wenlang, Zhou Peng, Lv Yitao, Source: CICC Insight, Original Title: "CICC: Smooth Transmission, Maintaining Steepness - Comments on the Resumption of Trading in Government Bonds in the Open Market"