How to Understand Supportive Monetary Policy: The Central Bank's Intentions and Adjustments in the Bond Market

The market has too many pranks and a lot of teasing. Until the recent adjustment in the market, which saw a 10 basis point adjustment over two weeks, it has felt like bonds haven't been this exciting for a long time. Although many people are still shouting, "Central bank, don't hit us anymore, look at our fundamentals, we can't just go up like this."

However, is the central bank's intervention really an intervention? Have bond practitioners overestimated their influence? Is it possible that the central bank actually doesn't care much about this adjustment?

Pulling up a chart: If we pull the axes back to December 1, 2024, for a long time, it has followed the logic of MTMJ, oscillating downwards until it reached a flattening curve stage.

At this time, many are waiting for another wave to charge forward, with the 10Y government bond heading towards 1.5 or even 1.4.

However, the steep bull has not arrived, but the steep bear has been seen. Is there any trace to be found in this adjustment?

Of course, the CPI data over the weekend may have reignited the bulls' fighting spirit: "Tell my mother, the fundamentals are still very poor!"

China's February CPI year-on-year was 0.7% according to Dongxin News on March 9 | China's February CPI year-on-year was 0.7%, expected 0.5%, previous value 0.50%; month-on-month was 0.2%.

In February, the prices of food, tobacco, and alcohol fell by 1.9% year-on-year, affecting the CPI decrease by about 0.54 percentage points. Among the other seven major categories, four rose and three fell year-on-year. Among them, prices for other goods and services and clothing rose by 6.5% and 1.2%, respectively, while healthcare and housing prices rose by 0.2% and 0.1%, respectively; transportation and communication, daily necessities and services, and education, culture, and entertainment prices fell by 2.5%, 0.7%, and 0.5%, respectively.

In February, the prices of food, tobacco, and alcohol fell by 0.2% month-on-month, affecting the CPI decrease by about 0.07 percentage points. Among the other seven major categories, one rose, two remained stable, and four fell month-on-month. Among them, prices for other goods and services rose by 0.7%; housing and healthcare prices remained stable; education, culture, and entertainment, and transportation and communication prices fell by 0.5% and 0.4%, respectively, while clothing and daily necessities and services prices fell by 0.1%.

Data, perception, and reality intertwine yet diverge, with bonds at this crossroads.

The orientation of monetary policy actually reflects the higher-ups' judgment and choices regarding these data.

The market tends to believe: severe cases require strong medicine.

However, the higher-ups' concerns run deeper: a policy orientation that minimizes side effects.

Thus, at present, the monetary policy's positioning is: a supportive role.

At the Lujiazui Forum on June 19, 2024, President Pan's speech may have provided some hints, with the original excerpt as follows:

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"The stance of China's monetary policy is supportive, providing financial support for the sustained recovery and improvement of the economy." Pan Gongsheng clearly expressed our country's monetary policy stance at the forum.

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Pan Gongsheng responded that some financial institutions have a strong "scale complex," achieving rapid expansion of scale through irrational competition. For unreasonable market behaviors that easily diminish the transmission of monetary policy, financial regulatory authorities continue to strengthen regulations, prevent fund idling, and rectify manual interest subsidies, etc ...

Monetary policy is a macro tool, but if the structure is not adjusted properly, it is difficult for macro control to effectively play its role.

Pan Gongsheng introduced that the People's Bank of China has been exploring the guiding role of structural monetary policy tools. Currently, the balance of structural monetary policy tools is about 7 trillion yuan, focusing on supporting key areas and weak links in the national economy, such as small and micro enterprises and green transformation. In the future, the People's Bank of China will improve the system of precise and moderate structural monetary policy tools, reasonably grasp the scale of structural monetary policy tools, and timely withdraw tools that have achieved phased goals.

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"It is difficult to maintain the overall credit growth rate at over 10% like in the past." Pan Gongsheng stated that when the growth of monetary credit has shifted from supply constraints to demand constraints, if the focus remains on the growth of quantity, it clearly contradicts the laws of economic operation.

...

From the aforementioned important meeting to the market's unilateral expectations and operations that disregard interest rate risks, we tend to believe that the adjustments may not be without clues; the market is simply worried about missing out, giving way to risk management. In this situation, everyone rises and falls together, leading to a frantic run under negative carry.

1. Cancel manual interest subsidies, standardize interbank deposits, and avoid irrational competition among banks, overall reducing structural distortions and non-market-based deformities on the liability side.

From this perspective, it is helpful to guide market prices downward, especially since manual interest subsidies have released a considerable amount of new allocation demand, and the thirst for safe assets has driven an overweight in government bonds. Therefore, the liquidity-driven bull market in bonds in 2024 is reasonable.

We excerpted from CICC's research analysis: Large banks' interbank deposits continue to flow out, while the structure of small and medium-sized banks is relatively optimized. This partly explains the rise in issuance rates of large banks' certificates of deposit, with the scale of large banks' interbank deposits exceeding 4 trillion yuan. Since January, the reduction in fund outflows from large banks has led to a tighter funding situation. In addition to credit issuance exceeding expectations, there has also been a year-on-year decrease of 1.4 trillion yuan in deposits. Specifically, large banks' corporate deposits decreased by 2.4 trillion yuan year-on-year, related to the Spring Festival factors; interbank demand deposits decreased by 1.3 trillion yuan year-on-year, mainly due to the outflow of funds after the reduction in interbank demand deposit rates since December. CICC estimates that from December to January, large banks' interbank deposits flowed out a total of about 4.4 trillion yuan, and it is expected that interbank deposits will gradually flow out in the first quarter, but the outflow magnitude will decrease. The liability structure of small and medium-sized banks continues to optimize. Despite the impact of the Spring Festival, in January, small and medium-sized banks' deposits only decreased by 545.2 billion yuan year-on-year, and the loan-to-deposit ratio was also significantly lower than the levels in January and February 2024. In January, the interest rates on time deposits of urban and rural commercial banks continued to decline. CICC believes this is mainly due to the self-discipline of deposit rates, leading to some deposits flowing from large banks to small and medium-sized banks, and the influence of the Spring Festival causing funds to flow to rural financial institutions. The proactive liability levels of small and medium-sized banks are also lower than the same period last year, and the liability structure continues to optimize.

Therefore, if the impact of interbank deposits gradually fades, the subsequent tight funding situation will weaken, and the forces dominating market adjustments in the short term may be alleviated in stages.

1. Desensitize credit growth rates and social financing data. With the actual existence of factors such as economic structural transformation and weakening demand, the effectiveness of monetary policy itself is diminishing, especially as a low-interest-rate environment continues to form Therefore, regarding social financing and other data, policies may gradually become desensitized.

The market may have an illusion that as soon as the data worsens, monetary policy will immediately ease, thus smoothing over the reality of poor economic performance during a bond bull market.

Is this possible? This clearly does not conform to the rules, as the effectiveness of monetary policy is significantly stronger in suppressing inflation and other aspects, while currently, fiscal policy needs to be coordinated. The supportive stance of monetary policy is also based on the objective environment.

Thus, many people currently tend to emphasize the reality of the fundamentals, insisting that monetary policy must be adjusted accordingly. However, how is this causal chain formed? What if there is no causal chain at all?

1. Structural monetary policy tools.

From a micro-research perspective, the central bank is indeed making great efforts to support the real economy, including small and micro enterprises and guidance for the real sector.

However, the linear thinking of the capital market is that when the economy is weak, it must prevent water leakage, hence a bond bull market is necessary.

But structural monetary policy tools are meant to guide funds to where they should go.

Otherwise, what does it mean to shift from virtual to real?

At the end of 2024, Moutai's recruitment of bond traders went viral, which may reflect the bond bull market dominated by excessively loose liquidity, with funds idling and clogging the financial system.

These are not what the central bank wants to see.

Therefore, the current flood of liquidity is of no use and may even accelerate the logic of idling, which also explains the timing of the central bank's reserve requirement ratio and interest rate cuts being further delayed.

Supporting this is structural monetary policy, hoping that funds truly reach the needed areas, which is also the fundamental meaning of support; at least the negative carry accumulated by short-term bonds has created systemic risks, and a correction can only be seen as a normal part of the process.

Here, let's popularize the structural monetary policy tools and their applicable scenarios:

Structural monetary policy tools are important means for the People's Bank of China to guide the credit direction of financial institutions and precisely support key areas and weak links of the national economy. Their core function lies in optimizing the credit structure and reducing financing costs in specific areas through targeted funding support or incentive mechanisms. Below are the main categories and typical representatives of currently existing structural monetary policy tools:

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Therefore, looking back:

1. The central bank is squeezing the irrational competition in scale and guiding liabilities downward, which actually helps to increase the transmission efficiency of monetary policy and is conducive to the demand for allocation of government bonds. The most typical example is the bond bull market following the manual interest subsidy in 2024;

2. However, preventing idle funds has led to delays in interest rate cuts and reserve requirement ratio reductions, with the central bank's attitude relatively firm in the short term.

3. The interbank certificates of deposit that were mistakenly punished are a short-term stress test to regulate interbank deposit behaviors. As these pressures are released, it may still be necessary to guide the reduction of liability costs, which would alleviate the situation of lacking liabilities, and interbank certificates of deposit will step down again.

4. The core contradiction of bonds is not the fundamentals, but the current idle funds and negative carry. The market is currently characterized by a long-term logic being short-termized, continuously pricing bonds through descriptions of fundamentals. The significant distortion of this anchor is due to negative carry, where the cost of funds exceeds the 10Y government bonds. This inversion will either require a rapid decline in funding costs or a correction in bonds. In the short term, a correction is the main focus; if funding costs continue to decline in the future and interest rate cuts open up space, then bonds will have a new pricing anchor In summary, the central bank may regard this adjustment as a routine matter, merely a continuation of policy, while the market overlooks interest rate risks and excessively overdraws on rate cut expectations, resulting in a normal correction.

The deeper reason is that supportive monetary policy arises because there are fewer effective actions that monetary policy can take, leading to reduced effectiveness. This is also a deep concern for the central bank, which has resulted in efforts to assess structural tools through patchwork measures.

Moving forward, if there is indeed a significant fiscal gap, fundamental factors will reassert their dominance over the downward trend; however, whether this fundamental aspect can reverse will constitute a new adjustment logic for bonds.

Currently, the bond adjustment merely reflects the pre-pricing of reserve requirement ratio cuts and interest rate reductions, and has not yet priced in a fundamental reversal.

Source: Xinbao Investment Research, Original title: "How to Understand Supportive Monetary Policy: The Central Bank's Intentions and Current Adjustments"