01

In January, the bond market faced expensive funding with a flat yield curve

1.1 The cost of capital is high

As the middle of January approached, monetary conditions became tighterThe weighted rates for both overnight and seven-day repos surged towards 4%, with daily fluctuations up to 10%. The tightness is attributed primarily to several factors; during this atypical period, the demand for cash skyrocketed around the Chinese New Year and tax payment deadlines

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An estimated 15 trillion yuan was withdrawn before the festival, paralleling the end of the month when a significant 995 billion yuan in Medium-term Lending Facility (MLF) contracts were due, alongside over 1 trillion yuan in tax paymentsAltogether, this resulted in a liquidity gap exceeding 35 trillion yuan.

Moreover, new regulations on interbank deposits triggered a loss of approximately 3 trillion yuan in deposits from non-bank financial institutions, leaving banks vulnerable on the liability sideLate in 2024, a self-regulation mechanism controlling the pricing of market interest rates for banks was introduced to promote the reduction of non-bank deposit interest rates and enhance bargaining power with corporate clientsInitially, these moves often lead banks to see a rapid outflow of deposits following any cuts in interest ratesFor instance, the last two months of 2024 saw banks gaining a net 1,800 billion yuan in non-bank deposits against a loss of 3,170 billion yuan, reflecting year-over-year declines of 13,900 billion and 26,374 billion yuan, resulting in overall losses of 30 trillion yuan and a staggering annual fall of 40 trillion yuan

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The primary impact fell on larger banks, whose added non-bank deposits plummeted by 46,000 billion yuan, while smaller institutions surprisingly saw slight growth.

A similar event occurred in April 2024 after the prohibition of manual interest supplementation, which resulted in corporate demand deposits dwindling by approximately 5.2 trillionNet borrowing in the interbank market went from 4-5 trillion previously to a mere 2-3 trillion, analogous to the current lending levelsHowever, during the period of reduced bank lending, funding conditions remained relatively stable; manual interest supplements shifted towards money market funds and various wealth management products, alleviating some pressure and erasing the heavy reliance on bank lendingYet, as January rolled in, withdrawals from these wealth management substitutes surged in response to the seasonal cash demands of the Chinese New Year, causing an overall depletion of liquidity in both banks and non-banks, resulting in soaring capital costs.

Additionally, with banks facing monetary pressure, the central bank’s methods for managing liquidity were cautious, leading to market expectations of rate cuts being dashed

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Instead of the anticipated adjustments, the People's Bank of China (PBoC) focused on reverse repos and buybacksNet liquidity injections amounted to 26 trillion yuan and 17 trillion yuan for both measures, with a reduced MLF of 200 billion yuan, resulting in a total of 35 trillion yuan being injectedAlthough these figures appear substantial, they fall short of previous practices whereby rate cuts were made to cushion against seasonal variations during the Spring Festival, leading to relatively higher borrowing costsCurrent rates for seven and fourteen-day reverse repos stand at 1.5% and 1.65% respectively, and banks must apply additional premiums, inevitably pushing funding costs upwardMoreover, the short duration of reverse repos and the delayed announcement of buyback terms often create unexpected tightness in liquidity conditions.

1.2 A flat curve

In the wake of tight liquidity, bond yields displayed stability on the longer end while quickly increasing on the short end, resulting in an extremely flat yield curve

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The yields on 10-year and 30-year government bonds declined by 4-5 basis points from the end of December to reach 1.63% and 1.87% respectively, while the month-to-month fluctuations for the 10-year yield were a modest 7 basis points, contrasted by a more expansive 11 basis point change for the 30-year bondsIn stark contrast, the 1-year and 3-year treasury yields significantly increased by 22 and 12 basis points, hitting 1.30% and 1.31%. The yield spread between long and short durations dropped from 59 basis points at the beginning of the month to just 33 basis points by the end, a mere fraction of the historical average (<10%) since 2019. The performance of local government bonds paralleled that of treasury bonds, though the steepening effect was even more pronouncedCredit bond yield curves were similarly flattening, with the yield on the 1-year AA+ local government bonds and AAA-rated secondary capital bonds soaring by 12-13 basis points, while the yields on 3-year and 5-year bonds changed minimally, increasing by less than 4 basis points.

From the perspective of institutional behavior, three driving forces propelled short-term rates upward significantly: firstly, the actions of foreign capital in a changing exchange rate environment

As President Trump’s inauguration approached, protective tariff expectations in early January pressured several currencies of non-U.Seconomies to weaken; the onshore RMB depreciated from 7.30 to 7.33 as external institutions capitalized on limited arbitrage opportunities in the swaps market, narrowing these margins to below 5 basis pointsConsequently, international entities began strategically offloading short-duration treasury bonds, resulting in a net selling of 23.6 billion yuan during the first week of January.

Secondly, after the new year, trading dynamics adjusted as funds acknowledged possible performance assessment mandatesWealth funds and asset management institutions typically enhance the scale in their portfolios by year-end, often favoring short-duration treasury bonds, and throughout the first half of January, these investment strategies provoked a series of redemptions

Subsequently, on January 6 and beyond, funds increased their sell-offs of shorter-duration bonds to maintain liquidity, net selling of 438 billion yuan in government bonds was noted between January 7-14.

Lastly, with funding becoming overly tight, institutions were compelled to reduce leverage or invest in higher-yielding alternativesReferencing the sentiment index from Minsheng Bank, by January 10, market conditions became noticeably tense; the high-pressure liquidity persisted for about five trading sessions, with rates for R001 and R007 surging to 3.94% and 4.19% respectively on January 16. The underlying trends slightly receded afterward, yet rates to support funding across the lunar new year maintained above 2.30%. In an effort to alleviate the persistent negative interest rate differential, institutions began offloading shorter-duration bonds

Between January 13-21, funds net sold 28 billion yuan in bonds maturing within a year and 33 billion yuan in longer-term credit bonds from January 14-24. Indicative of leveraged positions, the reduction was particularly noted among non-banking institutions, where leverage levels shifted from 114.2% at the start of January to 111.5% by month-end, nearing historical lows of 111.3% observed in early 2022.

Furthermore, in the context of the long end, the diminishing appeal of leveraged strategies and insufficient coupons to offset elevated costs led to a shift towards duration strategiesThis triggered more pronounced “long-end clustering” phenomena, where the impact of capital convergence on performance in the long-term market lessened.

02

In February, pressures from bond supply increase

However, liquidity may likely ease

Looking ahead into February, we anticipate a significant reduction in the funding gap compared to January; however, the outflow of non-bank deposits may persist amid uncertain central bank stances

Thus, while improvements are expected, the actual extent will depend heavily on the actions of the central bank.

Firstly, the anticipated improvements relate mainly to M0 returning to the banking system, diminished tax payments, and a decline in MLF maturities, collectively reducing the funding gap by approximately 4.3 trillion yuan compared to JanuaryThe seasonal return of cash post-festivities, approximating 700 billion yuan from the cash withdrawn prior to the New Year, marks a key variableSecondly, February is not marked by significant tax deadlines, meaning the fiscal measures are less impactful relative to January and typically contribute less than monthly expenditures, hinting toward an overall supportive scenario for liquidityLastly, MLF maturities are set to drop to 500 billion yuan, a significant decline from the substantial 995 billion yuan observed in January.

However, elevated pressures remain in February with respect to upcoming buyback expirations and augmented government debt issuance

Notably, 800 billion yuan in buybacks are set to expire around mid-February alongside 500 billion yuan in MLF contracts dueThis necessitates a significant evaluation of short-term liquidity in light of these pressures.

In terms of government debt, net issuances are expected to reach around 1.4 trillion yuan this month, reflecting year-on-year increases of 720 billion and 470 billion respectivelyThere are reports from 24 provinces outlining plans for 2,000 billion yuan in bond issuance, with 324.8 billion in new special bonds, 104.2 billion in general bonds, and 577.4 billion related to refinancing.

The anticipated conclusions are that upon aggregating local and national debt metrics, we see a net issuance around 1.4 trillion yuan for February, maintaining a year-on-year growth trajectory.

In summary, as funds are expected to return to banks post-holiday, and given that February does not coincide with substantial tax phases, the anticipated increase in government bond offerings may variably influence liquidity

Overall, the probability of marginal improvements in February's liquidity is elevated, contingent upon existing uncertainties amid low long-term rates, and we remain cautious as we project in varied scenarios:

In a scenario where the PBoC adopts a more accommodating stance by continuing bond purchases or reducing reserve ratios, benchmark funding rates may re-align towards normal levelsIn the wake of rate cuts from September 2024 onwards, R001 stands at around 1.6%, while R007 ranges between 1.8-1.9%, sidelining any extreme shifts seen in January 2025, notably a 40-50 basis point spread above normalized ratesUnder such conditions, liquidity improvement could stabilize.

Conversely, should the central bank maintain a conservative approach, we could see funding rates elevated by an additional 10-20 basis points

Non-bank deposits' outflows yield fragility in bank liabilities, with 800 billion yuan in buybacks due this monthA firm commitment to stability could keep liquidity tight.

Additionally, market dynamics align with tax periods and overlaps, pushing projections towards notable fluctuationsHowever, February lacks the layered pressures seen in early quarter or festival benchmarks, suggesting manageable volatility within the expected parameters.

03

Interest rate strategies: using the short end as a spear and the long as a shield

In January, long-end rates retained strength with three unexpected determinants: firstly, there was no overwhelming behavior among market participants to prematurely cash in; secondly, a notable liquidity challenge arose mid-month owing to the convergence of substantial taxes and the festivities, disrupting stable conditions and propelling borrowing costs upward across maturities; and thirdly, there was a retreat in expectations for economic stimulus as disappointing manufacturing data and tariffs led to visibly weakening demand indicators reflecting back into the bond markets.

Reviewing February's bond market outlook reveals a blend of conflicting variables, favoring potential repairs in the short to mid-segment of the yield curve

The supportive factors include a clear likelihood of recovery in liquidity; moreover, the start of the fiscal year often represents critical positioning opportunities for financial institutions, suggesting limited likelihood of drastic market adjustments amidst such backings; finally, persistent soft demand within the underlying economic framework underscores slower growth contrasts noted in January, with weak export orders emerging.

During the fluctuations of baseline data, the overarching trajectory for interest rates may not fully reverse; however, pressures faced by long-end yields bespeak several levels of resistanceInfluential headwinds consist of ongoing alterations in U.Stariff policies threatening monetary expansions and thus stifling improvementsA micro-view of January 2025 findings reflecting profound uncertainties echo this standstill.

In summary, the overarching sentiment reflects ongoing pressures that may manifest variably