In 2023, the economic recovery appears brighter compared to 2022, with a minimal likelihood of adjustments in the central bank's policy interest ratesIt is projected that the yields on 10-year government bonds may trend down towards approximately 2.60%. Recent trends since mid-April indicate a notable bullish phase in the Chinese bond market, with the yield on the 10-year government bonds dropping from 2.84% on April 17 to a record low of 2.69% by May 11 - a level not seen since November 10, 2022. Following that peak, the bond yields have entered a phase of fluctuation, oscillating between 2.69% and 2.72%.

The current market trend is underpinned by various factorsIn April, economic momentum seemed to weaken with a wide range of key statistics such as the Purchasing Managers' Index (PMI), consumer spending, investments, and industrial production figures not meeting expectations

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Notably, real estate investment saw a significant year-on-year decline of 6.2% for the first four months of the yearThe real estate sales figures have also indicated a slowdown, with the average daily transaction area for new residential properties in 30 major cities falling below the figures recorded in previous monthsThese diminishing fundamentals have given a supportive backdrop for the bond market.

Another contributing factor to the bullish phase of the bond market is the ongoing reduction in deposit rates by various banksSince April, some smaller banks and joint-stock banks have begun to follow suit with the rate cuts initiated by state-owned banks back in September 2022. By May 5, institutions such as Bohai Bank, Zhejiang Commercial Bank, and Hengfeng Bank also reduced their interest rates, with cuts ranging from 4 to 30 basis points across all tenors

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Notably, the rates for three and five-year fixed-term deposits fell beneath the 3% mark, landing between 2.90% and 2.95%.

In addition, starting from May 15, there was an adjustment to the self-discipline framework governing market interest rates, leading to a 30 basis point reduction for major banks and a 50 basis point cut for other financial institutions in the maximum rates for agreed and notice depositsThese shifts are a response to declining costs associated with bank liabilities, which have relaxed the banks’ requirements for asset yields while also contributing to an increased demand for bond investments, providing support for the foundational decline in bond yields.

The market has also witnessed a relatively loose funding environment, characterized by a robust inclination toward leveraging positions in bond purchases

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The average R007 rate saw a substantial decline of 20 basis points from March to 2.30% in April, and by May 26, it further decreased by 32 basis points to 1.97%. The disparity in the decrease of R007 rates compared to DR007 highlights that non-bank institutions are well-equipped financially, showing a strong investment hungerThis increase in leveraged purchasing behavior was particularly pronounced with the daily trading volume of repurchase agreements exceeding 7 trillion yuan for most of the latter half of April, even reaching a staggering high of 8.2 trillion yuan by May 24. Furthermore, since May, transactions in overnight repos have accounted for over 90% of daily trading volumes, showcasing that institutions are employing significant leverage to acquire bonds, thus supporting the ongoing bull market.

Historical perspectives shed light on the current market dynamics

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As of May 26, 2023, the yield on 10-year government bonds settled at 2.72%, positioning itself below the 4.3% percentile since 2002, which indicates a relatively low rate historicallySince the pandemic began in 2020, bond yields have traversed through three primary downward cyclesThe latest cycle saw a commence in late February 2023 and has accelerated since then, marking the third round of decreasing yields.

The initial cycle's nadir occurred on April 8, 2020, where the yield fell to 2.48%, the lowest since June 24, 2002. This profound decline was primarily a result of unexpected accommodative monetary policies implemented by the central bank during the first wave of the pandemicThe measures included targeted reserve requirement ratio cuts for smaller banks and reductions in the 7-day reverse repurchase and Medium-Term Lending Facility (MLF) rates by 20 basis points, alongside an unexpected lowering of the interest rate floor for excess reserve requirements.

The second downward cycle saw its lowest point on August 18, 2022, with yields tightening to 2.58%. This was largely propelled by the central bank’s unexpected cut in the 7-day reverse repurchase and MLF rates, raising market expectations for further monetary easing alongside rising concerns surrounding a resurgence of the pandemic impacting economic sentiment.

When analyzing the lower points from the historical cycles, both cycles were correlatively tied to unexpectedly looser monetary policies from the central bank along with ample liquidity within the interbank market

Such conditions led to substantial demand from financial institutions for bond allocationOn the specific dates when the 10-year yield hit its cycle lows during the first and second instances, the corresponding DR007 rates were 1.28% and 1.42%, which were historically at their 0.4% and 1.9% percentiles, respectivelyFurthermore, in relation to the timing of these cycles’ peaks and troughs, the extreme values in funding rates often emerged marginally earlier than those in the yields, typically spanning from one week to one month earlier.

Looking ahead, the bond market is expected to continue its oscillation in the short term, particularly for long-term bonds, while shorter tenors may prove more favorableAs yields decline and approach historically low levels, the appetite for cautious investment from market participants appears to be instigating a shift in investment strategies towards shorter durations, encouraging increased allocations for bonds with maturities of one year or less

The market remains in wait for further directives that could give context and clarity to the evolving situation.

In conclusion, it is anticipated that the yields on 10-year government bonds may trend down towards the 2.60% mark, aligning closely with the lows recorded in 2022. Currently, the economy is navigating through a challenging phase with three primary influences—weak underlying economic conditions, falling bank deposit rates, and improved liquidity—expected to persist and steer bond yields lowerDespite the stability of MLF and LPR rates, market mechanisms that govern pricing may lead to the initiation of a new phase of reductions in bank deposit ratesThis trajectory could potentially lead to new lows for funding rates in 2023. Given the stronger economic recovery in 2023 compared to 2022, the likelihood of significant adjustments in the central bank's policy rates remains low, and crossing below the previous low of 2.48% established in the first cycle might prove challenging for 10-year government bond yields.