How much have interest rate cut expectations been front-run in the bond market?

Summary

The expectation of an early interest rate cut and year-end positioning have jointly driven interest rates to new lows. In the past month, the bond market has experienced a very strong rally. The impressive performance of this wave can be attributed to multiple factors. Among them, the two core driving forces are the market's anticipation of future interest rate cuts and the momentum of the year-end market itself. As a result, the market has achieved the largest increase at the 20-day level since March 2020.

Next, the key question is how to assess the subsequent space and probability of success.

First, assess the potential space.

Year-end market perspective: There is still a space of 10-20 basis points in an optimistic scenario. Historically, the decline in the 10-year government bond yield during the year-end market has ranged from 10 to 50 basis points, with an average of 34 basis points. This round of decline is close to the historical average, but there are still 10-20 basis points away from the extreme value.

Interest rate cut expectation perspective: Based on a neutral interest rate cut expectation of 40 basis points, there is still about 10 basis points of space. Since the Politburo meeting signaled "moderate easing," the market's imagination of subsequent loose monetary policy has greatly increased. Observing the implied interest rate cut magnitude in the current market pricing from different angles, the average degree of anticipation is about 30 basis points. If we consider a neutral expectation of a 40 basis point cut next year, there is still about 10 basis points of remaining pricing space; if we consider an optimistic expectation of 50-60 basis points, there is still a space of 20-30 basis points.

Next, discuss the probability of success.

High-frequency fundamental data supports the probability of success. High-frequency signals from the fundamentals have continued to decline after peaking in the first week of November. In terms of financial data, the growth rate of medium- and long-term loans to enterprises continued to decline in November, and the slope has widened. Aside from the drag caused by the replacement of credit during the debt restructuring process, the endogenous investment and financing demand of enterprises remains weak. Therefore, the recent trend of interest rates does not diverge from the marginal changes in the fundamentals.

Sentiment indicators have sharply risen but have not yet entered the risk zone (>70%). In the past week, the micro trading thermometer reading in the bond market sharply increased by 8 percentage points to 65%. However, it has not yet reached the overheating zone, and there is still a certain gap from the year's high point (about 80%). In addition, the duration of all medium- and long-term pure bond funds has not yet risen above 3 years.

Furthermore, the current trend of declining interest rates has not yet been disrupted in terms of technical patterns. Therefore, the balance of market probability still leans in favor of the market. However, it is also recommended to closely monitor whether market sentiment further rises rapidly into the overheating zone and the intensified characteristics of recent long-end trading volume.

From the current position, analyzing from the perspective of space, the market pricing is approximately 10 basis points away from the neutral expectation; from the optimistic scenario of the year-end market, the space is between 10-20 basis points. In the short term, as market momentum is still present (the technical pattern has not been disrupted), and sentiment indicators have not yet reached the overheating zone, it is still recommended to follow the trend.

During this period, pay attention to several short-term profit-taking risk signals: 1) "Panic" buying signals (funds' net purchases in a single week reach or exceed the empirical threshold of 200-250 billion); 2) Sentiment indicators return to above 70% and approach the year's high point; 3) The price of funds has declined.

Main Text

Strategic Thinking: How Much Have Bond Markets Anticipated Rate Cuts?

Anticipation of rate cuts and year-end positioning have jointly driven interest rates to new lows. In the past month, the bond market has experienced a very strong rally. The remarkable performance of this wave of market activity is driven by multiple factors, including easing concerns about supply, the central bank not intervening after interest rates broke "2", contrasting sharply with the continuous regulatory warnings from April to August this year.

The two core driving factors are the market's anticipation of future rate cut space and the inherent driving force of the year-end market itself. Regarding rate cut expectations, since the Politburo meeting adjusted the monetary policy wording to "moderately loose," the market's imagination for rate cuts next year has significantly expanded and quickly reflected this expectation in bond pricing. Additionally, starting from mid-November, the bond market entered a traditional seasonal tailwind period, where institutions typically face concentrated release of allocation demands during the year-end phase, further boosting this rally.

On the other hand, negative factors are relatively absent in the short term. On one hand, the market remains cautious about the sustainability of slight improvements in the fundamentals, and the momentum and extent of economic recovery have not yet posed significant pressure on the bond market; on the other hand, aside from the adjustment in monetary policy wording, there have not been any overly unexpected changes in other policies recently.

Therefore, this wave of market activity has achieved the largest increase in 20 trading days since March 2020 (measured by the decline in the 10-year government bond yield over 20 trading days) under the multiple driving forces of "timing (policy direction, regulatory attitude), location (seasonal tailwind), and people (institutional anticipation of rate cuts)."

Next, the key question is how to assess the subsequent space and probability of success.

First, assess the space. Based on previous observations of the stable growth trading path, it can be generally considered that the period from October 8 to November 18 was an adjustment phase of oscillation and observation, where the market recovered from an "oversold state" to a "normal state." After November 18, the market officially entered a "direction selection period."

Based on the aforementioned phase division, looking at the starting point of this wave of market activity, we can use 2.10% (the position of the 10-year government bond yield on November 18) as a benchmark, and it has now declined to about 1.77%, a decrease of over 30 basis points. How much space is left? We can observe the potential space brought by the two main driving factors mentioned earlier in this wave of market activity.

Year-end market perspective: There is still a space of 10-20 basis points in an optimistic scenario. Based on historical experience, the decline in interest rates during the year-end market typically ranges from 10 to 50 basis points, averaging about 34 basis points The current downward magnitude is approaching the historical average level, but there is still a space of 10-20 basis points to the extreme.

Interest rate cut expectation perspective: Based on a neutral interest rate cut expectation of 40 basis points, there is still about 10 basis points of space. After the Politburo meeting released the signal of "moderate easing," the market's imagination of subsequent loose monetary policy has greatly increased. Observing the current market pricing implied interest rate cut expectations from different angles roughly reflects that the preemptive magnitude is between 20-35 basis points, with an average preemptive degree of about 30 basis points.

If we observe a neutral expectation of a 40 basis point interest rate cut for the entire year next year, there is still about 10 basis points of remaining pricing space; if we observe an optimistic expectation of 50-60 basis points for the entire year, then the pricing is still 20-30 basis points away from expectations.

Specifically looking at the measurement of various interest rate cut preemptive degrees:

(1) The preemptive magnitude shown by interest rate swaps is around 34 basis points. Recently, the IRS (FR007: 1 year) is around 1.45%, while FR007 (20-day MA) is around 1.84%. Measuring the pricing degree for interest rate cuts using IRS (FR007: 1 year) - FR007 (20-day MA) is about 38 basis points.

(2) The performance of floating rate bonds and fixed rate bonds in the individual market reflects a preemptive interest rate cut expectation of about 20 basis points. Selecting floating rate bonds and fixed rate bonds that have been actively traded in the past 20 days, and comparing the yield to maturity of floating rate bonds and fixed rate bonds with similar remaining maturities and issuers. On average, the individual bond level reflects a pricing of about 23 basis points for the interest rate cut.

(3) The relative market performance of floating rate bonds and fixed rate bonds reflects a very strong expectation of loose monetary policy. Based on the differences in relative strength performance of floating rate bonds during interest rate hike and cut cycles compared to fixed rate bonds, an observational index measuring the market's expectations of monetary tightening and loosening is constructed using the performance difference of representative indices of both. In the past week, the monetary easing expectation index has remained below the 1% percentile, indicating that the market has a very strong expectation of subsequent loose monetary policy.

(4) The preemptive degree from the perspective of interest rate change magnitude is about 26 basis points. Comparing the downward magnitude of market interest rates with other "slow rates" since the beginning of this year to measure the preemptive degree of market interest rates regarding the space for interest rate cuts Since the beginning of this year, the 10-year government bond yield has cumulatively decreased by 78 basis points (BP), while the policy rates for Open Market Operations (OMO), Medium-term Lending Facility (MLF), and Loan Prime Rate (LPR) for 1-year and 5-year have decreased by 30 BP, 50 BP, 35 BP, and 60 BP respectively. The fixed deposit rates for 1/3/5 years have decreased by 35 BP, 45 BP, and 45 BP respectively, and corporate loan and personal mortgage rates have decreased by 24 BP and 66 BP respectively. On average, the 10-year government bond yield has anticipated a rate cut of about 33 BP.

Overall, from the above four dimensions, it can be observed that the current market's expectation for interest rate cuts is very strong, with an anticipation exceeding the neutral expectation by approximately 30 BP.

Next, let's discuss several observation dimensions of the win rate.

The direction of interest rates does not deviate from the recent marginal changes in the fundamentals. After peaking in the first week of November, the high-frequency signals of the fundamentals continued to decline this week. In terms of financial data, the growth rate of corporate medium- and long-term loan balances continued to decline in November, and the slope has expanded. Besides the drag caused by the replacement of credit during the debt resolution process, the endogenous investment and financing demand of enterprises remains weak. Therefore, the recent trend of interest rates is consistent with the direction of marginal changes in the fundamentals.

The sentiment indicator has sharply risen but has not yet entered the risk zone (>70%). In the past week, the micro trading thermometer of the bond market has sharply risen by 8 percentage points to 65%. However, it has not yet reached the overheating zone and still has a certain gap from the year's peak (around 80%).

In addition, the duration of all medium- and long-term pure bond funds has not yet risen above 3 years. Furthermore, given that the current trend of declining interest rates has not been disrupted (the trend indicator has been bullish since November 8, and the volatility signal also turned bullish on December 2), the balance of the market's win rate remains on the favorable side. However, it is also recommended to closely monitor whether market sentiment continues to rise rapidly into the overheating zone.

Looking at specific indicators,

except for the slight decline in institutional leverage, fund - rural commercial bank buying volume, stock-bond ratio, and real estate ratio percentile values, all other indicator percentile values have risen; among them, the turnover rate of 30/10-year government bonds, TL/T long-short ratio, listed company financial management buying volume, commodity price ratio, and consumer goods price ratio percentile values have all significantly increased.

The currently crowded indicators mainly include the turnover rate of 30/10-year government bonds, the cumulative buying scale of ultra-long bonds by funds, monetary easing expectations, policy interest rate spreads, and stock-bond ratio indicators.

The ultra-long end has recently seen a noticeable increase in volume, with the trading activity of 30/10Y active bonds rebounding to a phase high, and the weekly trading share of bonds with maturities over 10 years rising to a historical high level. Attention can be paid to the potential increase in volatility brought about by the short-term speculative rise in these maturities.

From the perspective of the secondary market transaction structure, this week remains dominated by broad-based funds, with funds, other products, and financial management being the top three main buying forces, followed by insurance companies. The trading structure continues the characteristics observed since mid-November.

At the beginning of the month, when it just broke 2%, we advised everyone not to "get off the bus" too early. One of the reasons for that judgment was that market sentiment had not yet reached an extreme stage. Observing from the current perspective, analyzing from a spatial dimension, considering the market's generally optimistic expectations for interest rate cuts next year, static calculations based on a neutral expectation of around 40BP indicate that the current market pricing is approximately 10BP away from the neutral expectation; from the optimistic scenario of the cross-year market, the space is between 10-20BP. In the short term, as market momentum remains (technical patterns have not been broken), and sentiment indicators have not yet reached the overheating zone, we continue to recommend following the trend.

The short-term profit-taking risk signals to track are: 1) "panic" buying signals (funds' weekly net buying reaches or exceeds the empirical threshold of 200-250 billion); 2) sentiment indicators returning to above 70% and approaching the year's high; 3) funding prices realizing downward.

Trading Review: 10Y Down 18bp During the Week

Precise control, the central bank made a small-scale fund injection this week. Perhaps influenced by the marginal tightening of the funding situation in the previous period and the upcoming tax period, the central bank switched to daily net injections this week. Although the average daily net injection scale is not too large, against the backdrop of continuous net absorption last week and rising funding rates, the central bank's increased fund injection this week indicates that its attitude towards protecting and precisely controlling the funding situation remains unchanged. This week, a total of 354.1 billion 7-day reverse repos matured, and the central bank injected 538.5 billion in funds, with a total net injection of 184.4 billion in reverse repos The overall funding center is rising. This week, the central rates for various maturities have risen compared to the previous period, with DR001, DR007, and DR014 rising by 7bp, 11bp, and 13bp to 1.49%, 1.75%, and 1.85%, respectively.

From the weekly trend, DR001 and DR007 operated at high levels of 1.52% and 1.78% from Monday to Wednesday, and then significantly declined to 1.46% and 1.69% from Thursday to Friday; DR014 showed a generally upward trend, rising from 1.83% to a peak of 1.87% during the week. The rise in the funding center may be related to the still high scale of government bond payments during the week; however, the issuance of 2 trillion yuan in debt relief bonds has basically been completed this year, and the scale of government bond payments will significantly decrease next week, reducing subsequent disturbances to the funding situation. Attention should be paid to factors that may disturb the funding situation, such as tax periods, MLF maturities, and year-end.

The curve has shifted down significantly, with yields across maturities declining by about 16bp. This week, the yields on government bonds across various maturities have declined significantly, with declines ranging from 13bp to 19bp, resulting in an overall downward shift of the curve. Specifically, the yield on the 1-year government bond fell by 19bp to 1.16%, and the yield on the 10-year government bond also fell by 18bp to 1.78%, with the 10-1 maturity spread slightly widening from 61bp to 62bp.

In addition, the yield on the 5-year government bond fell by 18bp, while the yields on the 7-year and 15-year government bonds both fell by 16bp, the yield on the 30-year government bond fell by 15bp, the yield on the 20-year government bond fell by 14bp, and the yield on the 3-year government bond fell by 13bp.

The 10Y yield fell by 18bp within a week, setting a new historical low. Driven by factors such as the central economic work conference not introducing unexpected policies or statements, year-end allocation trends, and speculation about future interest rate cuts, the bond market yields fell sharply this week, with an unusually steep downward slope. After breaking below 2% earlier, the 10-year government bond yield easily broke through 1.8% during the week, closing at 1.78% on Friday.

Specifically: On Monday (December 9), the National Bureau of Statistics released the inflation data for November, showing that the CPI rose by 0.2% year-on-year (expected 0.5%), and the PPI fell by 2.5% year-on-year (expected to fall by 2%). However, the bond market did not react much to this.

Today's market was mainly driven by the political bureau meeting transcript released around 3:30 PM, which mentioned "implementing a more proactive fiscal policy and moderately loose monetary policy" and "strengthening extraordinary counter-cyclical adjustments." The release of the transcript immediately ignited market sentiment, opening up the market's imagination for future monetary policy, with yields on bonds across maturities quickly declining, and the yield on the 10-year government bond falling by 4bp to 1.92% on the same day On Tuesday (December 10), the General Administration of Customs released the import and export data for November, showing that exports in dollar terms increased by 6.7% year-on-year, compared to a previous increase of 12.7%. The market remained immersed in the bullish sentiment from yesterday, with bonds of all maturities maintaining a "fierce" downward trend, and the 10-year government bond yield fell by 7 basis points to 1.85%.

On Wednesday (December 11), the funding situation finally eased slightly, with the 10-year active bond maintaining a fluctuating trend in the morning and turning downward in the afternoon. After the market closed, Reuters reported that Chinese authorities might consider a weak yuan strategy in 2025 to respond to Trump's tariff policies, leading to further declines in bond yields. On that day, the yield on the 10-year government bond fell by 3 basis points to 1.82%.

On Thursday (December 12), funding continued to marginally ease, driving short-term government bond yields to decline rapidly, while the performance of short and long-term bonds diverged. On that day, the 1-year government bond yield fell by 6 basis points to 1.21%, while the 10-year government bond yield remained stable at 1.82%.

On Friday (December 13), short-term government bond yields further declined, with the yields on 1-3 year government bonds dropping by about 6 basis points. Due to the central economic work conference's press release published last night not exceeding expectations compared to the previous Politburo meeting, government bond yields quickly fell at the market open, with the 10-year yield breaking below 1.8% without resistance, and the 30-year yield also quickly declining to near 2%, briefly breaking below 2% during the day.

Throughout the day, the yield on the 10-year government bond fell by 4 basis points to 1.78%, and the 30-year yield also fell by 4 basis points to 2.01%.

The duration of funds continues to rise, with the degree of divergence remaining roughly the same as last week. From December 9 to December 13, the median duration of public funds increased by 0.03 to 2.94 years, placing it in the 81st percentile over the past three years. The duration divergence index remained at 0.55, in the 66th percentile over the past three years.

This week (December 8 to December 14), the signals released by the top ten synchronized indicators of interest rates are mainly "positive," accounting for 7 out of 10, with changes from last week including the US dollar index and the copper-gold ratio sending "positive" signals. **

Specifically: ① The year-on-year (6MMA) sales of excavators is 11.6%, higher than the previous value of 9.6%, attribute "bearish"; ② The year-on-year cement price is 17.3%, lower than the previous value of 20.0%, attribute "bullish"; ③ The year-on-year (6MMA) crude steel output of key enterprises is -18.7%, lower than the previous value of -2.4%, attribute "bullish"; ④ The year-on-year land transfer income is -22.9%, higher than the previous value of -24.6%, attribute "bearish"; ⑤ The iron ore port inventory is 140 million tons, lower than the previous value of 150 million tons, attribute "bullish";

⑥ The year-on-year PMI is -3.8%, higher than the previous value of -4.6%, attribute "bearish"; ⑦ The credit cycle is 4.0%, higher than the previous value of 0.7%, attribute "bullish"; ⑧ The bill financing is 14.3 trillion, higher than the previous value of 14.1 trillion, attribute "bullish"; ⑨ The US dollar index is 106.6, higher than the previous value of 106.2, attribute "bullish"; ⑩ The copper-gold ratio is 15.69, lower than the previous value of 15.72, attribute "bullish".

Article authors: Yin Ruizhe S1450523120003, Liu Dong, Wei Xue, source: Ruizhe Fixed Income Research, original title: "How Much Rate Cut Expectation Has the Bond Market Rushed Ahead?"

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