How to understand the central bank's suspension of government bond purchases? CICC: Reserve requirement ratio cuts and interest rate reductions will continue, but the pace may depend on multiple factors

On January 10, the People's Bank of China announced that starting from January 2025, it will suspend open market treasury bond purchase operations, and will consider resuming them based on the supply and demand conditions of the treasury bond market. We believe the reason for the suspension of treasury bond trading by the People's Bank is concerns about potential risks in current market pricing.

On one hand, long-term treasury bond yields are approaching the lower end of historical experience corridors, leading to a decrease in investment cost-effectiveness; on the other hand, the market has incorporated a considerable amount of interest rate cut expectations into the "moderately loose" monetary policy, which has already been somewhat anticipated. Looking ahead, we believe that reserve requirement ratio cuts and interest rate cuts will continue, but the pace may depend on multiple factors.

To lower real interest rates, it is necessary to reduce nominal interest rates on one hand, but also to raise inflation expectations on the other. Against the backdrop of still weak private credit demand, boosting demand and prices largely depends on the strength and pace of fiscal expansion. In addition, in the context of high risk premiums, the central bank's efforts to play a role in macro-prudential and financial stability functions, maintaining stability in financial markets, are also worth noting, rather than just focusing on operations that adjust risk-free interest rates.

Long-term treasury bond yields are approaching the lower end of historical experience corridors, leading to a decrease in investment cost-effectiveness. A similar investment to treasury bonds is deposit investment; both have no credit risk and are somewhat substitutable, with the difference being that treasury bonds have price fluctuations, which are relatively higher than deposits. From historical experience, the corridor for China's 10-year treasury bond yield is generally capped by the standing lending facility and floored by the 3-year deposit rate. Currently, the 10-year treasury bond yield is already close to the 3-year fixed deposit rate, and the yield advantage brought by treasury bond investments relative to deposits has significantly decreased.

Chart: 10-year treasury bond yield approaches the lower end of the experience corridor

Source: Wind, CICC Research Department

The market has incorporated a considerable amount of interest rate cut expectations into the "moderately loose" monetary policy, and the interest rate cut expectation index shows that the market expects the magnitude of interest rate cuts in 2025 to exceed that of 2024. The reason the 10-year treasury bond yield has approached the lower end of the experience corridor so quickly is largely due to interest rate cut expectations. The interest rate cut expectation index calculated through derivative pricing shows that the market expects the magnitude of interest rate cuts in 2025 to exceed that of 2024. From the trend of the index, this expectation was significantly strengthened after the central government proposed a "moderately loose" monetary policy in December.

Chart: Market expects the magnitude of interest rate cuts in 2025 to be greater than in 2024

Source: Wind, CICC Research Department However, based on historical experience, changes in policy statements have partially reflected the monetary policy operations prior to the changes, expressing a "supportive" attitude. For example, in November 2008, the State Council shifted the tone of monetary policy from "tight" to "moderately loose," and the Central Economic Work Conference in December continued the "moderately loose" stance. In the previous quarter, interest rates had already been cut by 189 basis points and the reserve requirement ratio by 150 basis points, and thereafter, only one interest rate cut of 27 basis points and one reserve requirement ratio cut of 250 basis points occurred within a month. Before the tone was set at the Politburo meeting and the Central Economic Work Conference in December last year, both the open market operation rates and the lending and deposit rates had already been lowered, expressing a "supportive" attitude.

The goals of monetary policy are multiple, aiming to reduce the financing costs for the real economy while also paying attention to the potential secondary risks arising from the rapid decline in government bond yields. In terms of monetary policy objectives, in addition to growth and prices, the central bank also needs to consider internal financial stability and balance of international payments. In the second half of 2024, we have seen the central bank raise concerns about interest rate risks multiple times. On June 14, the Financial Times published an article pointing out that "further interest rate cuts face dual constraints from internal and external factors. Internally, the net interest margin of banks continues to narrow. Externally, the exchange rate of the renminbi is also a factor to consider... There are many current negative factors, which investors have either intentionally or unintentionally ignored. We expect investors to pay more attention to the price volatility risks of bond assets at this time, to protect their 'purses'." In the monetary policy implementation report for the second quarter of 2024 released by the central bank in August, it explicitly stated, "Conduct stress tests on the risk exposure of financial institutions holding bond assets to prevent interest rate risks." These concerns and constraints have eased somewhat since the fiscal policy has gained momentum since the end of September, but after the recent rapid decline in government bond yields, related concerns and constraints have returned to the central bank's view, which may be the main reason for the central bank's suspension of government bond purchases.

Chart: Relevant statements regarding interest rate downward constraints before the end of September

Source: See chart, China International Capital Corporation Research Department

Looking ahead, we believe that reserve requirement ratio cuts and interest rate cuts will continue, but the pace may depend on multiple factors. In addition to relying on nominal interest rate cuts, raising inflation expectations is also very important for lowering real interest rates, and the effects of fiscal expansion in this regard are relatively more significant. The Central Economic Work Conference not only proposed a moderately loose monetary policy but also suggested "a more proactive fiscal policy," and it is rare to emphasize stabilizing prices during a low inflation phase. Raising prices requires enhancing the demand for money as a medium of exchange while reducing the demand for money as a store of value. In the context of weak private credit and a strong preference for liquidity, an important way to enhance the demand for money as a medium of exchange is to improve the supply of money, which means increasing fiscal monetary input. If inflation expectations are effectively raised, real interest rates will decline, and the endogenous momentum of economic recovery will also improve accordingly In addition to lowering the risk-free interest rate (interest rate cuts), the efforts of monetary policy to reduce risk premiums are also worth noting. The 2024 Central Economic Work Conference clearly stated, "Explore and expand the macro-prudential and financial stability functions of the central bank, innovate financial tools, and maintain financial market stability" [2]. This means that the central bank will continue to work on managing risk premiums. From the latest press release of the central bank's monetary policy committee meeting [3], we expect that the central bank will likely make attempts in risk premium management over the next year, with three possible directions: first, support for small and micro enterprises and key areas of financing; second, support for revitalizing existing commercial housing and land; third, maintaining financial market stability.

Authors of this article: Zhou Peng S0080521070001, Zhang Wenlang S0080520080009, Source: CICC Insights, Original title: "CICC: Observing Monetary Policy Dynamics from the Suspension of Treasury Bond Purchases"

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