Since December, the bond market has been on a rising trend, largely attributed to the anticipation of interest rate cutsInvestors are reacting to projections suggesting that by 2025, the central bank may reduce rates by 30 to 40 basis pointsThis sentiment is reflected in the decline of the 10-year government bond yield, which fell below 2% and has now settled at around 1.72%. In contrast, the equity markets have exhibited subdued performance, shifting their focus toward dividend assets instead of growth.

The bond market has witnessed an impressive surge since the beginning of DecemberFollowing a dip in 10-year bond yields below the crucial 2% mark, rates continued to plummet to approximately 1.72%, marking a cumulative decrease of nearly 30 basis points within the monthThe yield on the 30-year government bond has also dipped around 1.95% recently.

At the end of November, a meeting was convened to discuss a self-regulatory mechanism concerning market interest rates, aiming to refine the adherence to deposit rates by non-bank financial institutions

This policy initiative was expected to enhance the transmission of interest rates, further energizing the ongoing downward trend in government bond yieldsBy December 9, a meeting had laid out a more optimistic macroeconomic policy direction, specifically stating a commitment to a "moderately accommodative monetary policy." This approach has driven the bond market to anticipate future rate cuts, especially in light of a sluggish demand for real economy financing, an overarching excess of liquidity, and a lighter supply of government bonds compared to previous yearsSuch conditions contribute significantly to the persistent decline in government bond yields.

Looking back at the bond market throughout 2024, it maintained a pronounced bullish trend despite facing disruptions caused by central bank risk warnings, growth stabilization measures, and fluctuations in the equity market

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The bond market trajectory can be segmented into various phases:

The first phase, from the beginning of 2024 until early March, saw a consistent decline in the 10-year bond yieldAt the start of the year, the focus was on preventing capital churn, leading to a noticeably contracted asset supplyThe phenomenon of "asset scarcity" emerged as the market struggled to find favorable allocation options, leading to the downward pressure on bond yieldsThe 10-year bond yield tumbled from nearly 2.6% at the start of the year to about 2.3% by early March, marking a decrease of over 30 basis points.

The second phase, spanning from mid-March to the end of June, was characterized by market fluctuationsAfter initially dropping to relatively low levels, the central bank began issuing caution regarding risks associated with long-term rates in this period

April witnessed a regulatory halt on manual interest subsidies, tightening liquidity for deposit-taking institutionsAs a result, the 10-year bond yield fluctuated within a range of 2.23% to 2.38% during this phase.

In the third phase, from early July to the end of September, bond yields continued their downward trajectory propelled by rate cuts from the central bankThe authorities intensified their guidance on long-term interest rates, and on July 1, they announced measures allowing for bond borrowing, leading to subsequent market volatilityHowever, following a significant unexpected rate cut on July 22, the broader interest rate curve shifted downward, with the 10-year yield nearing the 2.0% mark by mid-September.

The final phase, from the end of September to the present, saw a notable adjustment in the bond market due to the release of various incremental policies

Despite this, government bond yields entered a downward channel once again in DecemberFollowing a comprehensive policy rollout on September 24 regarding reserve requirement ratio cuts, interest rate reductions, and new monetary tools to support the equity market, the equity markets surged, leading to a notable bond market pullbackNonetheless, the central bank's commitment to moderately accommodative monetary policy declared on December 9 hastened the anticipation for rate cuts, resulting in further declines in bond yields.

From a theoretical standpoint, bond yields reflect both underlying economic fundamentals—such as growth, inflation, and policy factors—and are also influenced by supply and demand dynamics, affected by shifts in risk appetiteOver various periods, different factors may play leading roles in determining bond yield movements.

Although there were expectations for a looser policy at the end of September, a steep drop in risk appetite, particularly manifesting in a rapid rise in equity markets, caused a shift in bond yields, pushing them higher

Furthermore, in the second quarter, constant warnings from the central bank regarding long-term bond rate risks led to turbulent adjustments in bond yields.

Nevertheless, these two factors were primarily short-term influences on bond yields in 2024, while fundamental trends driving a gradual decline in government bond yields stemmed from low inflation levels and a shift towards looser monetary policy since the end of September.

Bond yields are essentially the market's representation of nominal risk-free ratesRapid inflation would lead to increased bond yields, while persistently low inflation would pull bond yields lowerBetween January and November, consumer price index (CPI) growth stood at 0.3% year-on-year, markedly below the 1.4% average observed between 2020 and 2023.

In terms of supply and demand, there has been a slowdown in local government bond issuance due to policies aimed at debt reduction

Consequently, the supply of high-yield assets has diminishedAdditionally, changes to the manual interest subsidy framework and the self-regulatory measures to ease deposit rate declines have led capital to migrate towards wealth management, monetary funds, and bond funds, heightening demand for bond allocation amid these asset shortages.

Policy-wise, the meetings on December 9 and the central economic work conference held on December 11-12 shaped monetary policy towards a "moderately accommodative" stanceNotably, the last instance of a policy stance being termed "moderately accommodative" occurred during the central economic work meetings of 2008 and 2009 when there were substantial cuts in policy rates and reserve requirements, subsequently causing a vigorous rebound in social financing scales and money supply growthThe latest meeting indicated readiness to "timely cut reserve ratios and interest rates while maintaining ample liquidity," prompting anticipatory moves toward rate cuts within the year-end bond market.

As for these expectations around future rate cuts, how much are they truly reflected in the current bond yield levels?

A recent survey conducted by Huatai Securities among banks, brokerages, mutual funds, insurance areas, and private investment groups indicated that half of the respondents expect the 10-year bond yield to drop to 1.5% in 2025, with a majority estimating a potential interest rate reduction of around 40 basis points by that time.

However, in contrast to the bond market's optimism regarding substantial future interest rate cuts, the reaction observed in the equity markets towards monetary policy easing has been somewhat tepid

The Shanghai Composite Index neared the 3500 point mark on December 10 before receding to about 3400 points, indicating a divergence in how the bond and equity markets price future policies and economic fundamentals.

Huatai Securities points out that while the bond market may retain some momentum in the short term, long-term rates currently reflect already priced-in expectations of more than 30 basis points of interest rate cutsThus, for bond yields to break below certain thresholds, new catalysts must emerge, and as the importance of trading escalates, significant reversals in trends will necessitate indications of re-inflation as well as a recovery in financing demand.

Furthermore, Guosheng Securities noted that medium-term adjustments by institutions may constrain the downward movement of bond yields

For one, the inverted yield curve across asset-liability scenarios may pose a risk observation point in the market over the medium termPresently, banks are issuing high-cost certificates of deposit while simultaneously adding bonds with lower yields, creating a disconnectIn the past month alone, there was a net financing scale of 1.3 trillion yuan for bank-issued certificates of deposit, compared to just 230 billion yuan during the same period in 2023. Currently, the yield on one-year AAA certificates of deposit is at 1.63%, slightly exceeding that of bonds with a maturity of seven years or lessGiven this landscape, banks may find it challenging to offset costs by adding more bonds, especially when conditions lean towards an increasing supply crunch post-year-end.

Additionally, the bond market has priced in expectations of eased policy; therefore, unless influenced by stronger anticipated policy changes, the downward movement of interest rates could encounter some limitations

Traditionally, short-term rates presented by certificates of deposit are closely aligned with funding prices; currently, the price of certificates already mirrors a degree of interest rate cut expectationsIf a 30 basis points cut scenario were to unfold, funding prices may stabilize around 1.45%, with certificate rates predicted near 1.54%, translating the anticipated yield on the 10-year bond down to around 1.72%, which suggests current rates already embed a certain level of cuts.

If the interest rates enter a stabilization phase marked by negative yields, the market would potentially experience de-leveragingAs the cost of capital surpasses most short-term bond yields, uncertainties linger on whether there can be sufficient easing post-Year EndShould long-end bonds encounter a bumpy ride without further capital gain prospects, the current negative yield situation might lead to decreased leverage in the market, thereby diminishing demand for long-term bonds.