A dramatic transformation is underway in the financial landscape of China, prompted by a significant announcement from the People’s Bank of China (PBOC). This morning, the central bank declared that starting in January 2025, it will suspend its open market operations involving the purchase of government bonds, a decision which will be reconsidered based on the supply and demand dynamics of the bond market.

The immediate aftermath of this announcement witnessed an escalating trend in interbank interest ratesThe yields on five-year and ten-year government bonds rose by 4 basis points within the day, while the thirty-year bonds saw an increase of 3 basis pointsFurthermore, the principal contract for thirty-year Chinese government bond futures experienced a significant dip, expanding its initial loss to 1.1%.

In parallel, the foreign exchange market showed volatility; the offshore yuan against the dollar soared nearly 100 points in a short span, reaching a quote of 7.3472. The Hang Seng Tech index initially surged by as much as 1%. However, the A50 index faced a notable decline, with the dividend index also turning bearish, while indices tracking smaller cap stocks like the CSI 1000 and the Guozheng 2000 exhibited intermittent strength.

The Market Dynamics Unveiled

By January 10, a shift in market logic became evident

In the bond markets, government bond yields were consistently on the rise, with the opening of government bond futures indicating a 0.89% drop in the thirty-year principal contract which quickly widened its decline to 1.1%.

The principal contracts for ten-year and five-year bonds also opened lower, down by 0.27% and 0.27% respectively, while the two-year bond futures faced a modest fall of 0.13%.

The 'perpetual bonds' in the interbank market also exhibited aggressive yields, where the yield on the “24 CCB Tier 2 Capital Bond 02A” climbed by 7.25 basis points, and “24 CCB Tier 2 Capital Bond 03BC” saw an increase of 8.5 basis points, while “24 BOC perpetual bond 02BC” rose by 5.5 basis points.

The offshore yuan currency again showed fluctuations, briefly jumping nearly 100 points to settle at 7.3472. The Hang Seng Tech Index expanded its gains to about 1%, with notable increases in stocks like Huahong Semiconductor and SMIC, both of which rose over 5% and 4%, respectively

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However, the A50 faced a stark downturn, and the banking sector also suffered a significant sell-off.

Market analysts suggest that the previous appeal of dividend assets was largely predicated on the continual decline in government bond yieldsNow that the yields are bouncing back, the allure of these dividend assets may diminish accordingly.

Guan Tao, the global chief economist at Bank of China Securities, highlighted the long-term downward trend in China's potential economic growth rate, which implies a decline in the neutral interest rate incorporating inflationThe rapid decline in nominal rates is largely due to actual economic growth falling below potential outputShould supportive policies and structural reforms enable the economy to exceed its potential growth, it might alter the current trajectory of nominal rates

The approach for long-term investors is becoming increasingly complex as they navigate these changes in allocation strategy.

Will the Rally in Government Bonds Come to a Halt?

Central bank Governor Pan Gongsheng has repeatedly cautioned about the systemic risks associated with the unilateral decline of long-term rates since June of last yearThe central bank began warning as early as April regarding risks tied to the one-sided descend of long-term interest rates.

Changcheng Securities previously noted in their research that the extreme emotions and behaviors in the bond market have turned overly prominent, with irrational fervor leading to the traditional indicators failing to functionThe ten-year government bond yield has significantly shifted from its peak of 2.24% in October, dropping dozens of basis points and nearing new focal points

Moreover, this yield is now over 30 basis points below the Medium-term Lending Facility (MLF) rate of 2.0%, with the gap against the Open Market Operations (OMO) rate of 1.5% reaching a historic maximum, reducing to less than 20 basis points.

There are concerns that the bond market's performance has become excessively aggressive – factoring in the potential pace of future rate cuts without actual changes results in a ten-year government bond rate realistically centered around 1.8% to 1.9%. Consequently, the current environment is more emotionally driven and influenced by institutional behavior, with noticeable speculative tendenciesInvestors are engaging in anticipatory layouts, embroiled in a spiral of competitive overreaching, which could result in new lows in the short term, followed by emerging battlegrounds between buyers and sellers – prompting caution regarding a potential retracement after extreme trading.

Ming Ming of CITIC Securities interpreted the central bank's decisive reverse-repurchase operations as primarily referencing the 2025 schedule for local bond issuance, alongside the MLF’s net withdrawal scale

They anticipate a steady increase in net government bond purchases, boosting the central bank's share in the overall bond market, thus more effectively leveraging liquidity support toolsHowever, in a phase of rapid rate declines, the central bank might primarily aim to adjust the yield curve, potentially engaging in a strategy of buying short-term and selling long-term bonds, including the likelihood of outright net sales.

China Huaneng Power Consulting emphasizes the need to monitor supervisory actions influencing institutional behavior and the implications of improvement in equity markets affecting asset allocationSpecifically, changes in regulations that may impact the overall liquidity in the bond market need close watching, especially regarding the risk of fund redemptions amplifying market volatilityDuring fast adjustments in the bond market, it is vital to monitor market movements and alter duration strategies promptly

Additionally, while funding prices might see temporary recovery post-year-end, the two weeks leading to the Lunar New Year usually tighten seasonallyThe government bond issuance pace could be front-loaded this year, making significant liquidity easing less likely in the short term, which may constrain the compression of credit risks in short-term bondsHowever, the spreads for mid to low-level credit bonds with durations between two to five years still present reasonable protection and are expected to contract further.

Zhaolian Financial's chief researcher Dong Ximiao stated that the central bank's decision to suspend government bond purchases aids in balancing the supply and demand in the government bond marketWhile government bond purchases serve as a key mechanism for liquidity injection, their suspension does not automatically imply tightening market liquidity