When and where will the bond adjustments take place?

01 When and Where Will the Bond Adjustment End?

Recently, the adjustment speed of the bond market has accelerated, spreading from short-term adjustments to medium and long-term adjustments. When will this adjustment end, and to what extent? This mainly involves the following questions:

First, why the adjustment? The market previously over-leveraged expectations for interest rate cuts and reserve requirement ratio reductions, with the curve moving ahead of monetary policy easing. Previously, the 10-year government bond yield fell to 1.6%, implying market expectations that the Open Market Operation (OMO) rate would drop from 1.5% to 1.1%. However, recent information indicates that expectations for short-term interest rate cuts and reserve requirement ratio reductions have decreased, and the repurchase rate far exceeds the OMO rate of 1.5%. In reality, not only has there been no interest rate cut, but there was even a brief interest rate hike. Therefore, the recent adjustment is a correction of the overly optimistic expectations in the bond market.

Second, to what level should the adjustment reach to have a margin of safety? In the short term, the market's pessimistic expectations for the macro economy persist, so even if bond yields adjust, it will not completely eliminate the bond market's expectations for future interest rate cuts. It will only correct the overly aggressive expectations for the space of interest rate cuts.

If the bond market retains expectations for interest rate cuts and anticipates a 20 basis point reduction in OMO in advance (even if there are multiple interest rate cuts this year, a reasonable market rhythm is to expect step by step, rather than fully exhausting expectations at once). Considering that the OMO rate is already the core anchor of market pricing, with an OMO rate of 1.3% plus at least a 40-50 basis point spread, this means that the 10-year government bond yield needs to reach 1.7-1.8% to match the market's implied expectation of a single interest rate cut and to have a certain margin of safety.

The positioning of the 5-year government development bond yield. Historically, the 5-year government development bond yield has not been lower than the OMO rate, nor lower than the 1-year time deposit rate, and currently, it is significantly inverted compared to the 1-year time deposit rate. Therefore, although the 5-year government development bond has adjusted recently, its cost-effectiveness remains relatively low compared to the 1-year time deposit.

Of course, if the macro data released later proves that, along with the implementation of various policy stimuli from last year and the technological support this year, the economy begins to stabilize, then the market will further lower interest rate cut expectations, and the pressure for bond adjustments will increase.

Third, when will the adjustment end? There needs to be a triggering factor for the central bank to return to a loose monetary policy track: This could be macro data from January to February, or even the first quarter macro data showing that the economy remains weak; or an external environment deterioration requiring domestic easing to hedge against it. However, there is significant uncertainty here, and it can only be tracked, making it difficult to predict in advance.

Fourth, where are the variables?

(1) Since the beginning of the year, the weighted average of the interbank DR007 has been around 1.9%, higher than the OMO rate of 1.5%. Currently, the market still uses the OMO rate of 1.5% as the pricing benchmark to consider the positioning of rates at various points on the curve. If DR007 continues to be higher than OMO, the market will ultimately position the yield curve based on the actual level of DR007.

(2) How much impact does technological development have on monetary policy? Deepseek has triggered a bull market in technology stocks, essentially due to significant breakthroughs in technology, reflecting the achievements of developing new productive forces in recent years. Logically, if stimulating traditional industries, low interest rates are indeed needed, as these industries are capital-intensive and sensitive to interest rates; If we rely on technology to drive the economy or reduce the demand for a low interest rate environment. If the application of Deepseek in the upstream and downstream becomes more widespread in the later stages and ultimately drives the economy, it may also reduce the space for monetary easing.

Of course, the impact of a technology stock bull market on the bond market is also a consideration. After all, such experiences are relatively rare in the history of bonds in China, and there are not many references available. We can only proceed step by step.

(3) After the acceleration of government bond issuance in the later stage, if interest rates rise too quickly, will the People's Bank of China inject liquidity to hedge against the rise in interest rates?

Therefore, in terms of future uncertainties, both bearish and bullish factors objectively exist. Strategically, interest rates have not yet returned to a point with a preliminary safety margin, and there is considerable uncertainty in the future. It is recommended to be cautious and observe for now. More importantly, after experiencing a few years of a bond bull market, when bond yields are already relatively low, the consideration of risk should weigh more in investments.

02 Tuesday Strategy Review

Logic of tighter-than-expected liquidity: Bond market strategy (2025-2-18)

[Bond Market Tracking] Yesterday, interest rates showed a fluctuating upward trend. In the morning, influenced by tight liquidity and the warm winds in the technology sector over the weekend boosting market expectations, interest rates rose slightly. After the market opened, stocks opened high but fell low, and in the afternoon, there was a significant drop, leading to a decline in interest rates. However, in the last trading session, the stock market quickly rebounded into the green, combined with the continuous tightening of liquidity, interest rates accelerated upward. Throughout the day, the yield curve steepened, with medium and short-term rates generally rising by 2-3 basis points, and long-term and ultra-long-term rates rising by more than 3 basis points.

Since mid-January, except for a brief easing due to cash inflow after the Spring Festival, liquidity has continued to show a tight pattern. The reasons for this include not only credit issuance being higher than historical levels but also the net issuance of interest rate bonds progressing faster than historical levels. The insufficient and slow pace of the central bank's liquidity injection to counteract this is undoubtedly a significant reason. Why has the central bank maintained a hawkish monetary policy tone during the liquidity gap period since the beginning of the year? How should we view the future trends in liquidity?

First, external uncertainties are ever-present. Since the beginning of the year, the central bank has maintained a hawkish policy tone, and external constraints are undoubtedly an important triggering factor. Whether in monetary policy meetings or monetary policy implementation reports, the resolute prevention of exchange rate risks is a key content, indicating the importance of exchange rate stability to the central bank. On one hand, from the influencing factors of the exchange rate itself, there is an objective existence of endogenous depreciation pressure on the exchange rate due to the divergence of economic and inflation expectations and the high level of the China-U.S. interest rate differential; on the other hand, since Trump's administration, the increase in policy uncertainty has not only intensified short-term fluctuations in the exchange rate but also raised the necessity of policy discretion Secondly, the objective requirement to prevent the idle circulation of funds. Although the continuous easing of monetary policy since last year has somewhat reduced the financing costs for the real economy, the issue of insufficient financing demand has not truly improved. The easing of monetary policy has not genuinely boosted economic expectations, and a large amount of excess liquidity has accumulated in the bond market, driving interest rates down too quickly and exacerbating financial risks. Therefore, the fourth quarter monetary policy execution report proposed "smooth monetary policy transmission mechanisms, better grasp the relationship between stock and increment, focus on revitalizing existing financial resources, and improve the efficiency of fund utilization." Revitalizing the stock and improving efficiency undoubtedly requires a moderately tight liquidity environment.

Thirdly, the policy coordination window has not yet arrived. Since the first quarter, although the supply of interest rate bonds has accelerated compared to the same period in previous years, it has not significantly deviated from seasonal patterns. Routine fluctuations such as cash withdrawals during the Spring Festival can be adequately addressed through policy tools like open market reverse repos. In the context where the higher-ups have not yet set the tone and fiscal policy has not significantly exerted force, the timing for monetary policy to coordinate efforts has not yet come, and the incremental monetary policy tools are correspondingly delayed.

Fourthly, signs of a bottoming out in the fundamentals have appeared. Since the fourth quarter, with the introduction of a series of unexpectedly strong macro policies, the downward trend in economic data has been reversed, the economic growth target for the entire last year has been successfully achieved, and credit and social financing hit new highs in January, with continued enthusiasm in the consumption sector. In the short term, the necessity for monetary policy to further exert force to stabilize growth is not strong.

Looking ahead, although exchange rate pressures have eased in the short term, as the aforementioned logic has not significantly changed, the central bank's attitude is unlikely to undergo fundamental changes. Monetary policy will focus more on offsetting funding gaps, and significant easing is unlikely in the short term. Possible changes may come from increased external pressures forcing policy intensification, and from the funding demand brought about by policy coordination efforts. Attention should be paid to subsequent signals related to Sino-U.S. frictions and fiscal efforts.

Waiting for right-side opportunities: Bond market midday strategy (2025-2-18)

[Bond Market Tracking] In the morning, bond market yields rose sharply across the board, influenced on one hand by the continuation of stock market sentiment, with sector rotation in the stock market boosting risk appetite and continuously suppressing bond market sentiment; on the other hand, against the backdrop of MLF maturities, the central bank continued to net withdraw liquidity in the open market, conveying a hawkish monetary policy signal, with a tight funding situation driving the yield curve to flatten upwards. By midday, the yields of actively traded bonds across various maturities rose by 3-6 basis points.

From the market performance in recent trading days, on one hand, the initiation of sector rotation in the stock market, coupled with global funds reassessing the value of Chinese assets, may lead to an unexpected continuation of the stock market trend, and the transmission of sentiment to the bond market through the stock-bond seesaw effect may also last longer. On the other hand, through the sustained net withdrawal of liquidity during the recent tight funding phase, the central bank has clearly conveyed its policy intention to stabilize the exchange rate and prevent risks. With interest rate risks not fully released and the external pressure and policy coordination window not yet arrived, an early shift to easing by the central bank could lead to a waste of previous efforts, and one should not overly expect the central bank's hedging strength. The absolute level of interest rates remains relatively low, and the market adjustment pressure is still in the process of being released; there is no need to rush to bottom-fish on the left side, and patience is required to wait for right-side opportunities Author of this article: Zhu Dejian S0360622080006, source: Qu Qing Bond Forum, original title: "When and Where Will Bond Adjustments End? — Huachuang Investment Advisory Department Bond Daily 2025-2-18"