Where is the new "anchor" for interest rates?

Key Points

Event: In the past two weeks, we have intensively visited many institutional investors. Our observations and conclusions are as follows, for the benefit of investors.

Comments: During the roadshow, bond market sentiment soared again, and interest rates hit new lows. Several factors contributed to the decline in interest rates: including weak economic data, the lack of implementation of fiscal stimulus in September, increasing expectations of rate cuts and reserve requirement cuts, changes in the expression of annual economic targets, the central bank's lack of strong measures to prevent the decline in interest rates, and net purchases of short-term bonds by major banks pushing down short-term rates. After breaking below 2.1%, the 10-year government bond yield continued to test lower, once again breaking through a key market level. As of September 14th, the 10-year government bond yield closed at 2.04%, with only 4 basis points away from the 2% integer mark, indicating that China's bond market may not be far from the "1%" era.

Despite the strong performance of the bond market, investors have their own concerns and difficulties. Insurers are struggling with the rapid decline in interest rates this year, with each pullback being too small, making it difficult to find suitable opportunities to increase positions, facing significant under-allocation pressure, and having difficulty operating on the asset side. In addition, recent regulations have pushed insurers to lower guaranteed interest rates, establish mechanisms linking guaranteed interest rates to market rates, and dynamically adjust them. Although this may help insurers reduce pressure on the investment side in the long run, the cost of existing funds is too high, and "distant water cannot quench immediate thirst." Insurers may be adjusting their allocations "in rhythm" at the current interest rate level, also possibly due to the greater "interest rate differential loss" from not allocating, making balance sheet contraction reasonable but not ideal. Wealth managers are concerned that the rapid decline in bond yields may prevent them from achieving performance benchmarks, leading to a deteriorating investor experience and subsequent redemptions.

Looking ahead, with deposit rates falling, poor stock market performance, and continued decline in housing prices, residents lack alternative investment channels, giving wealth management a "comparative advantage." Bond funds are also reluctant to see interest rates decline too rapidly, as in a low-interest rate environment, not only does the difficulty of obtaining alpha increase, but general adjustments and "toolization" positioning may ultimately backfire. Investors generally agree on the gradual decline in interest rates, but seem to struggle with the idea of continued decline, finding it challenging to balance fundamental guidance and central bank guidance.

Against this backdrop, investors' questions focus on several areas. How should current interest rates be priced, and where is the new "anchor"? How to view the risk points in the future bond market, when will long-term rates turn, and what conditions are needed? And some questions about institutional behavior, such as when will the large net purchases of short-term government bonds by major banks stop? How long can wealth management's accumulated floating profits and low volatility mode continue? Let's provide some perspectives for consideration.

Question One: Limited Disagreement on Fundamentals

Fundamentals determine the trend of the bond market, and the current focus is mainly on two core issues: one is how to achieve this year's growth target? In August, PMI, M1, industrial added value, and other data all indicate increased pressure to achieve this year's target. However, we have also noticed that the expression of the target has changed from "unwavering" to "striving to achieve," which still needs confirmation at the October Political Bureau meeting. Obviously, in an environment of insufficient total demand, monetary policy lacks transmission mechanisms, and while reserve requirement cuts and rate cuts are necessary, fiscal stimulus is more targeted. However, different policy choices have significantly different implications for the bond market Second, how to reverse the price signal? China's PPI data has been negative for more than 20 consecutive months, with nominal GDP weaker than real GDP. Continuous weak price signals can affect microeconomic behavior, such as companies being unwilling to hold inventory or invest, and households being unwilling to consume. At this time, debt is more rigid than asset prices, which may trigger a spiral feedback loop. We believe that reversing this round of price signals needs to start from both supply and demand. On one hand, various measures such as fiscal stimulus need to boost total demand, and on the other hand, policies like unifying large markets need to drive supply clearance. In our view, the effectiveness of these measures will ultimately be reflected in capacity utilization rates.

Question 2: Where is the new "anchor" for interest rates?

Since the beginning of this year, the problem of long-term interest rates "losing anchor" has become more apparent:

First, historical anchors have become ineffective with limited reference value. Long-term interest rates have continuously hit new lows, and we are in a new development stage of a century of changes and the transition of old and new dynamics, with no historical references to rely on.

Second, the MLF policy rate is no longer the official anchor. Previously, the MLF was the "anchor" of the bond yield curve, with the market referencing the MLF rate for pricing 1-year AAA interbank certificates of deposit and 10-year government bonds. However, at the Lujiazui Forum in June this year, Governor Pan Gongsheng confirmed that the MLF policy rate will gradually be phased out, leaving only the 7-day reverse repurchase policy rate. Bond yields have started to deviate from the MLF operation.

Third, the anchor of fund rates + term spreads. Fund rates connect the 7-day reverse repurchase policy rate and the 1-year government bond rate. Normally, the fund rate DR007 fluctuates around the 7-day reverse repurchase rate, and the 1-year government bond rate fluctuates around the fund rate. However, recent operations by the central bank in buying and selling government bonds, as well as large banks' continued net purchases of short-term government bonds, have caused short-term government bond rates, and even the entire yield curve, to deviate from the fund rate. The anchor of fund rates + term spreads has also become ineffective.

Fourth, the central bank's "psychological anchor." Since April, the central bank has been talking about long-term interest rates, showing a clear "bottom-line thinking," indicating that the market believes the central bank has a "psychological anchor" for long-term interest rates. The latest psychological anchor for the 10-year government bond is estimated to be at 2.1%, but it has already been effectively broken through last week. The breakthrough of the central bank's psychological anchor has made it difficult for investors to decide between taking profits and continuing to go long.

So, are there new anchors in the bond market to refer to? We attempt to provide a few perspectives. Firstly, whether the above third and fourth anchors have truly become ineffective may still require some time to observe. Fund rates + term spreads remain the core pricing logic. Central bank operations are the focus, including whether the central bank will once again take "strong" measures to prevent interest rate declines, and when the behavior of large banks' significant net purchases of short-term bonds will stop. Secondly, the breakthrough of the 2% integer threshold for the 10-year government bond may face certain resistance, observing regulatory trends and institutional operations around the 2% threshold. Thirdly, if the above fail, it must be acknowledged that there is a lack of clear, forward-looking pricing anchor points for government bond yields in the short term, and where the 10-year government bond below 2% will go lacks a reference point

Question 3: What are the potential triggers for the subsequent bond market adjustment?

In our report on August 29th, "Redemption Feedback Calmed Down? - Experience and Enlightenment of Four Rounds of Redemption Feedback," we mentioned that if there is a significant adjustment in the subsequent bond market, on the one hand, fundamental or policy factors that determine the market trend should undergo changes, serving as the main theme and trigger for the bond market adjustment; on the other hand, there should be vulnerable points in the market behavior of institutions, acting as a catalyst for market adjustment. Let's investigate from these two aspects.

Although the current bond market appears strong, it also has vulnerable points. Three observation dimensions are provided: First, from the perspective of stress testing, bond market adjustments occurred in early and mid-late August, triggering market redemption panic. However, in the two rounds of adjustments, the maximum adjustment range of bonds was only a dozen basis points, seemingly showing resilience. Second, from the perspective of institutional behavior, institutions with long duration mismatched with liabilities, unstable wealth management scale, weakening of low-volatility wealth management models, gradual consumption of historical floating profits, using bond funds as liquidity tools, and conservative institutional sentiment in the fourth quarter will all exacerbate the instability and volatility of the bond market. Third, from the bond market valuation perspective, whether it is the absolute level of interest rates or various spreads, including yield spreads, credit spreads, credit rating spreads, and variety (private placement, perpetual bonds, etc.) spreads, have all been compressed to historical lows.

However, the real risk undoubtedly depends on the fundamentals, with fiscal policy at the core. Subsequent fundamental changes or stable growth policies may be difficult to see fundamental shifts and are unlikely to become the catalyst for a significant bond market adjustment. There is not much disagreement in the current market about the trend of fundamentals. Regarding stable growth policies, the recent change in the expression of the annual economic target from "firmly complete" to "strive to complete" implies a decreasing possibility of stable growth policy exceeding expectations. In addition, the high market attention on relaxation of real estate policies and fiscal stimulus policies is also unlikely to reverse market expectations on fundamentals. Specifically:

Policy Variable 1: Relaxation of real estate policies. Currently, there are few remaining tools in the real estate policy toolbox, and the highly anticipated and likely to be implemented tools are reducing existing home loan interest rates and property inventory policies.

If the policy of reducing existing home loan rates is implemented, it will have two impacts on the bond market:

Impact Path 1: Improving fundamental expectations, slightly bearish for the bond market. How significant will the effect be? Let's make a simple calculation. In an extreme assumption, considering existing home loan rates at 4.6% and new home loan rates at 3.45%, the maximum interest rate cut space is over 100 basis points, but the actual implementation may be discounted. In the report released on September 2, 2024, "Window of Stable Growth and Expectations May Open," the Huatai Macro team calculated that if there is a 100 basis point interest rate cut, it could save residents' interest expenses by 250-300 billion yuan. If all the saved interest expenses by residents are used for consumption and without considering the multiplier effect of consumption, the impact on GDP growth is not significant, only around 0.3%. Therefore, the effect of this policy on improving fundamental expectations is relatively limited, and its bearish effect on the bond market is also not significant Impact Path Two: Compressing Bank Net Interest Margin, Leading to Downward Pressure on Liabilities + Price Comparison Effect, Benefiting the Bond Market. In the second quarter of this year, the net interest margin of commercial banks has been too narrow, at only 1.54%, a significant decrease of 15 basis points from the end of the previous year. Taking the year-end 2023 data of listed banks as a sample, we calculated that if the existing mortgage interest rates are reduced by 30/50/70/100 basis points, the corresponding narrowing of the bank's net interest margin would be 3.9/6.5/9.1/13.1 basis points, with a more pronounced effect. After the net interest margin declines, the urgency of lowering interest rates on the liability side of banks increases significantly, leading to further capital flow to non-banking sectors, while the relative price comparison effect of bonds is enhanced, benefiting the bond market.

Considering the comprehensive impact of the two aspects, the bond market tends to interpret this policy from the perspective of the price comparison effect. Therefore, this policy not only did not become the fuse for the bond market adjustment, but instead slightly favored the bond market. Of course, considering the need to balance various interests, even if implemented, it is likely to be a compromise solution with minimal actual impact.

Policy Variable Two: Fiscal Stimulus. The September session of the National People's Congress Standing Committee has concluded, with the expectation of fiscal stimulus falling short in this phase, and the October session of the Standing Committee is the next observation point. Whether there will be fiscal stimulus, the scale, method, and direction of the stimulus are the main focus points.

Firstly, from a quantitative perspective, if a fiscal stimulus of 1 trillion yuan is entirely invested in infrastructure and other projects, the economic boost would be 0.3-0.6% (fiscal multiplier of 0.4/neutral 0.8 * fiscal deficit increase of 0.8% = 0.32%/0.64%), while a fiscal stimulus of 2 trillion yuan would boost the economy by 0.6-1.2%. In reality, if the stimulus is used for local government transfers and other purposes, its contribution to the economy would be significantly reduced. Therefore, a 1 trillion yuan stimulus has limited impact on the fundamentals, while a stimulus of 2 trillion yuan or more is worth paying attention to.

Secondly, from the perspective of the stimulus direction, if more fiscal funds are used for real estate destocking, renovation, residential subsidies, etc., it would be more favorable for economic recovery or the cycle. However, if the funds are used for debt restructuring, transfers, etc., they would not generate physical work and have a smaller economic stimulus effect.

Thirdly, from the perspective of the method, whether to bring forward next year's plans to this year, or introduce new plans this year, whether to implement it through government bonds or other means, will also have different impacts. If implemented through government bonds, a 1 trillion yuan fiscal stimulus would correspond to a monthly average net financing scale of government bonds in October-December of just over 1 trillion yuan, with manageable impact; a 2 trillion yuan fiscal stimulus would correspond to an average monthly net financing scale of government bonds of about 1.5 trillion yuan, creating significant supply pressure.

Considering the current situation, we believe that there is an urgency for fiscal stimulus, but the scale is unlikely to exceed 1-2 trillion yuan, and the method is even more uncertain.

In conclusion, whether it is relaxation in real estate or fiscal stimulus, both will bring disturbances but do not have a trend effect. Apart from these, where are the real risks that the market needs to pay attention to? Regulatory policies are more worth watching: firstly, when will the tax exemption policy for funds be lifted, which could cause significant market impact if implemented; secondly, will there be stricter regulations on low-volatility wealth management products, and when will the low-volatility model be exhausted, which we will discuss in detail in the following sections. **

Question Four: Large Banks' Net Buying Behavior of Short-term Interest Rates is Puzzling

Since June this year, the funding rate (20-day moving average of DR007) has been continuously inverted with the 3-year government bond rate. Recently, the inversion degree between the funding rate and the government bond rate has deepened. Starting from September, the funding rate has inverted with the 5-year government bond rate. The direct cause of this phenomenon is that large banks have increased their buying of short-term government bonds recently. We discussed this phenomenon in our report "An 'Abnormal' Phenomenon in Curve Shape" on September 8th, suggesting three possible reasons behind it: first, this year, regulators have mentioned multiple times about "maintaining a normal upward-sloping yield curve," corresponding to buying short and selling long, and large banks may also have the responsibility to maintain the curve shape; second, regulators have duration restrictions on large banks' bond investments, with local government bonds and government bonds having longer durations in the first half of the year, objectively requiring buying short-term bonds for hedging; third, after passively selling long bonds, large banks have to buy government bonds within 3 years to maintain their bond allocation.

How should we evaluate the effectiveness of this operation? The original intention of large banks' "buying short and selling long" operation is to maintain a steep yield curve and prevent rapid decline in long-term interest rates. However, objectively speaking, the decline in short-term government bond rates has increased the cost-effectiveness of medium and long-term bonds, and the decline in long-term interest rates has opened up space, leading to an accelerated decline in long-term interest rates. So, when will large banks stop this behavior? We believe it mainly depends on the regulatory attitude. We can continue to observe the trend of short-term interest rates and synchronous indicators such as large banks' net buying of short-term bonds in the secondary market. In addition, paying attention to whether the central bank will make a statement on this issue (such as in the third quarter meeting) to respond to market concerns may have some forward-looking significance. Furthermore, considering the possibility of government bond issuance in the fourth quarter, the strength of large banks in allocating short-term bonds may face certain tests.

Question Five: How Long Can the Accumulated Unrealized Gains and Low Volatility Mode of Wealth Management Last/How Much Market Adjustment Can It Withstand?

In April, the prohibition of manual interest supplementation, the self-discipline mechanism for deposit guidance leading to a decline in deposit rates, and regulatory requirements for trust screening and cooperation with wealth management have weakened the low volatility mode of wealth management. Although existing wealth management products still have some low volatility protection, due to the increasing difficulty in cooperation between wealth management and trusts, the low deposit rates for new establishments, new wealth management products have less low volatility protection. Moreover, over time, the low volatility protection of old products is gradually expiring and decreasing.

The accumulated unrealized gains in the history of wealth management will also be gradually consumed. Previously, wealth management cooperated with trusts, accumulating a considerable amount of unrealized gains. However, when bond market returns continue to decline or when there are market fluctuations, if wealth management returns fail to meet the performance benchmark, there may be situations where historical unrealized gains are used to subsidize wealth management. This also means that over time, the accumulated unrealized gains in wealth management will be gradually consumed.

In terms of the fourth quarter, how much market volatility can the accumulated unrealized gains and low volatility mode of wealth management withstand? It varies depending on different wealth management situations. Micro research shows that some wealth management sub-products entered the low volatility phase early, with sufficient low volatility protection, accumulating more unrealized gains, and not having too aggressive performance benchmarks, thus being able to withstand more market volatility, such as 30-40 basis points; some wealth management sub-products entered the low volatility phase slightly later, able to withstand smaller market volatility, such as 20 basis points; On the more extreme end, some wealth management products have basically lost their low volatility protection, with very limited ability to withstand market fluctuations. Therefore, if there is an adjustment in the bond market in the future, wealth management products will also be impacted based on their ability to withstand such shocks. However, it is worth noting that currently, the low volatility protection of wealth management products is significantly stronger than at the end of 2022, with relatively better performance stability, which can still maintain net asset value stability in the short term and reduce the probability of large-scale redemption feedback.

In summary, **10-year government bonds have entered a "no man's land." In the short term, the key risks in the bond market are fiscal stimulus, regulatory policies, actions of financial institutions, and the market's own fragility. Looking ahead, if the fundamental factors determining the bond market trend do not change, 2% may also not be the "end point." In terms of operations, in the short term, it is still favorable to hold time deposits and 5-7 year treasury bonds, hold perpetual bonds, prefer credit bonds (commercial bank bonds) and policy bank bonds over government bonds in the 1-3 year range, and reduce the price-performance ratio of ultra-long-term risky credit bonds. If reserve requirement ratio cuts and interest rate cuts are implemented, and market sentiment reaches an extreme stage, it may be prudent to realize profits on long-term interest rates to guard against potential disturbances such as fiscal stimulus.

Author of this article: Researcher Zhang Jiqiang SAC No. S0570518110002, Source: Huatai Securities, Original Title: "Seeing Interest Rates Break Key Levels Again - Roadshow Feedback"