Why do bank stocks rise while A-shares fall?

Introduction

Since May this year, a very strange phenomenon has emerged in the capital market: on the one hand, bank stocks have continued to rise; on the other hand, the CSI 300 Index has continued to decline.

Many investors, based on intuition, have placed bank stocks on the opposite side of the stock market and launched a series of criticisms. They explain that in response to the stock market downturn, investors have clustered into bank stocks, which in turn has led to further market decline.

However, this explanation is not really an explanation, it simply rephrases the phenomenon in a different way.

In this article, we intend to provide a more robust explanation, where a certain factor X has led to both the rise of bank stocks and the decline of the CSI 300 Index.

Furthermore, we will identify this factor X, and integrate the interest rate transmission mechanism, stock market, and bond market into a whole.

The Rise of Bank Stocks Driven by Liabilities

Let's start with the bank side, this year the favorable factors encountered by banks are mainly on the liabilities side, that is, reducing the cost of bank liabilities.

1. Crackdown on manual interest rate hikes;

1. Lowering deposit rates;

1. Lowering OMO rates;

1. Lowering MLF rates;

1. Net purchase of government bonds;

These measures will all reduce the cost of bank liabilities, either by reducing the bank's ordinary liability costs or reducing the bank's interbank liability costs. Therefore, these policies will drive the rise of bank stocks from the cost side.

Rate Cuts and the Rise of Risk-Free Rates

A large amount of deposits have shifted from banks' on-balance sheet to off-balance sheet, especially bank wealth management products.

So, what does this have to do with the stock market?? This will significantly increase the expected returns of wealth management products, thereby raising the system's risk-free rates.

Current wealth management products have two significant differences from the past: 2. Net Asset Value (NAV) Management;

As shown in the above figure, these two new features will lead to an upward spiral between expected returns and capital gains.

When external forces such as "cracking down on manual interest rate subsidies" cause the scale of wealth management to expand, the capital gains of long-term bonds will increase, significantly boosting the expected returns of products. The increase in expected returns will then attract other social funds, leading to further expansion of the scale of wealth management.

This positive cycle will significantly alter the interest rate transmission mechanism, as interest rate cuts will result in an increase in risk-free rates, because interest rate cuts will increase the capital gains of long-term bonds.

The above figure shows us this mechanism, where the various interest rate cuts by the central bank will have two parallel effects, firstly, reducing interest income for the entire system; secondly, increasing the capital gains of long-term bonds. The combined effect of these two is an increase in the expected returns of wealth management products and a rise in risk-free rates.

Understanding this principle, we can understand how the current wave of "redemptions" in stocks came about. Its root lies in the massive capital flows caused by a series of interest rate cuts, with funds from many stock funds being swept up and joining this wave of capital flows.

Of course, the mechanism behind this is very obscure, leading to significant attribution difficulties for investors. Faced with a stock market decline, they either resort to "lack of social confidence" or attribute it to "bank stocks clustering".

Central Bank's Remedial Actions and Two-Stage Interest Rate Cuts

It is obvious that the central bank understands this "peculiar mechanism".

During the interest rate cut process, the central bank will repeatedly emphasize "long-term bond risks". In the eyes of the market, this is very awkward, leaving them at a loss—they want "short-term interest rates to fall" while also wanting "long-term interest rates to remain unchanged".

However, from the central bank's perspective, its demands are very clear: to reduce interest income from various assets, but to not raise risk-free rates too quickly.

In fact, at this stage, we don't have many good options. We can only accept this kind of two-stage interest rate cut process:

Stage One: The central bank reduces the income of various interest-bearing assets, passively increases the system's capital gains, boosts the system's risk-free income, and suppresses the prices of risky assets;

Stage Two: Fiscal stimulus policies are implemented, capital gains are significantly reduced, risk-free rates plummet, and the prices of risky assets rebound rapidly.

China's monetary policy seems to be inseparable from fiscal stimulus at the end point.

The capital market is very smart. Even if everyone is not clear about the principle of two-stage interest rate cuts, everyone is waiting for that turning point - the "fiscal stimulus event" that eliminates long-term capital gains.

The recent suspected stimulus is the "reduction of existing loan interest rates". Last week, foreign capital led a wave of expectations, but expectations fell back this week.

In fact, the market's feedback has been very positive, with a turnover of 880 billion yuan generated by just this small article.

The market knows very well what it needs.

Issues with Mechanism Design

The positive feedback mechanism of wealth management is a new institutional issue that did not exist before. Here, we must pay attention to one point: long-term debt must be combined with net asset value.

Combining long-term debt with redemption will not result in positive feedback, because the returns given to customers on the liability side are fixed. For example, we have had banks and insurance companies buy long-term debt for many years, but this situation has not occurred.

Combining high coupon rates with net asset value will also not result in positive feedback, because the returns on underlying assets are fixed. For example, having wealth management hold non-standard assets and credit bonds will not lead to this situation.

Ultimately, the problem lies in the combination of capital gains and net asset value, which will lead to a strong herd effect. In fact, we have experienced similar situations, but they occurred in stock funds.

Public fund issuance was extremely hot around the end of 2022, ultimately due to this positive feedback. However, the herd effect in stocks does not affect interest rate transmission, whereas the herd effect in bonds does affect interest rate transmission.

So, how to solve this problem? From the wealth management side, there are two solutions: 1. Return from net asset value to redemption; 2. Limit the ratio of wealth management and its underlying products buying long-term debt. Both of these solutions are not very reliable, the first one is like reversing, and the second one is unfair. After all the pushing and pulling, the final solution is to strengthen the central bank's intervention ability in long-term debt rates.

In the future, the central bank's long-term monetary injection mechanism will undergo a transformation, shifting from the method of reducing reserve requirements + net injection of MLF to buying national bonds, which will cause the central bank to passively hold a large amount of national bonds, thereby having stronger control over long-term bond prices.

As shown in the above figure, when the central bank needs to suppress capital gains, it will reduce the holding ratio of long-term debt; when the central bank needs to lower long-term debt rates, it will increase the holding ratio of long-term debt.

Therefore, when the new tools are in place, the central bank can simultaneously control the system's interest rates and capital gains, becoming a complete central bank:

1. Control the level of interest rates in the system through the scale of holding government bonds;

2. Control the system's capital gains through the ratio of holding long-term bonds;

As shown in the above figure, with these two tools in place, the central bank's control over the risk-free interest rate will be more direct and precise, no longer leading to a situation where "the market does not heed the central bank's call."

However, at this stage, we can only endure the pains of reform and this somewhat strange two-stage interest rate reduction mechanism, as well as wait for the uncertain "fiscal stimulus."

ps: Data is from Wind, image is from the internet

Original title: "Reform of Interest Rate Transmission Mechanism and Its Impact on the Stock and Bond Markets"