Fed Rate Cuts Drive Down Bond Yields
On September 18, the Federal Reserve made a significant announcement, reducing interest rates by 50 basis points. This marked the first decrease since March 2020, eliciting a rapid response from the Chinese bond market on the morning of September 19. Investors in China were quick to react, and the impact was felt almost immediately across various maturities of government bonds.
The early trading session witnessed a decline in rates for both short- and long-term bonds. The yield on 30-year government bonds fell to 2.1475%, while the yield for 10-year bonds dropped to 2.0250%, a level approaching the critical 2% threshold. This reaction highlights a pattern observed in previous interest rate cuts by the Fed, which historically lead to substantial declines in the 10-year bond yield in China.
Analyzing past occurrences, it becomes evident that every rate cut by the Federal Reserve has had a significant downward effect on China’s 10-year government bond yields. These cuts have previously resulted in declines of approximately 35 basis points, 162 basis points, and 47 basis points respectively during prior cycles. Such pronounced movements reflect the interconnectedness of global financial markets, particularly between the United States and China.
Market analysts suggest that the Fed's recent decision could lead to a narrowing of the interest rate spread between the U.S. and China. This narrowing will, in turn, influence capital flows within China and impact the exchange rate of the Renminbi. In recent days, the Chinese bond market has shown robust performance, evidenced by an easing yield curve trend even in the absence of extensive fiscal policy measures.
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On the same day as the Fed's announcement, yields in the interbank bond market further declined. By the time of reporting, the 30-year government bond yield reached a new low not seen since February 2005, while the 10-year yield also declined to its lowest since April 2002. This ongoing downward trend raises questions about future yield movements, with predictions suggesting that the 10-year government bond yield might soon drop below the 2% mark.
Since the beginning of 2000, there have been three notable periods of interest rate cuts by the Federal Reserve, each corresponding with notable decreases in China’s financial markets. The first series of cuts began on January 31, 2001, lasting over two years and resulting in a 35 basis point drop in the yield of 10-year Chinese government bonds. Following this, the 2007 financial crisis saw the Fed announce cuts that led to a staggering 162 basis point decrease in the yield during the subsequent years. The last major reduction phase occurred around 2019 to 2020, where the yield decreased 47 basis points.
Interestingly, the Fed's latest dot plot projections illustrated a median expectation for the federal funds rate at 4.4% for 2024, down from a previous expectation of 5.1% in June. This signals a potential for further action, with speculations of an additional 50 basis point cut by the end of the year. Amid this climate, analysts anticipate that yields could continue their downward trajectory.
Debate within market circles hints that the Chinese bond market could soon enter what some are terming the "1% era." This speculation is not without merit; in the week leading up to the Mid-Autumn Festival, yields on Chinese government bonds consistently reached new lows. The 10-year government bond yield saw a remarkable descent from 2.10% to approximately 2.04%, with short-term rates following suit and dipping around the 1.33% mark.
A local institutional investor in Shanghai was quoted saying that the yield's decline below the psychological 2.1% level signifies a trend towards even lower rates, with estimates suggesting it could fall below 2% before the end of September. “The market will attempt to push the 10-year government bond yield below 2%,” said Fu Peng, chief economist at Northeast Securities, highlighting the urgency of the current policies aimed at fostering a risk-on environment in the markets.
Analyst Zhang Jiqiang from Huatai Securities noted several factors contributing to the declining rates. Weak economic data, impending fiscal measures, and rising expectations for further cuts all combined to create an environment conducive to falling yields. Additionally, significant net purchases of short-term government bonds by major banks have skewed funding rates, further complicating yield dynamics across maturities.
The behavior of institutional investors has also evolved, as evidenced by trends observed in September’s market performance. Analysts pointed out that this current long bond rally is mainly being driven by trading, with state-owned banks and various commercial banks offloading long-duration bonds. Meanwhile, insurance companies are stepping in to absorb this supply while mutual funds and brokers remain only lightly engaged.
Once the yield for the 10-year government bond does breach the 2% level, clarity around future pricing benchmarks will likely remain elusive. Observations indicate uncertainty about how low yields can progress without signposting clear metrics for valuation.
Despite the strong upward movement depicted in the bond market, risks of a market adjustment loom on the horizon. Analyst Yan Ziqi from Huaan Securities cautions that rapid declines in long-term yields can attract regulatory scrutiny. This trend has emerged as yields have shifted from a stable 2.30% state in the second quarter, supported now at the psychological threshold of 2.10%, and further down to the current 2.04%. The pace of this decline may raise alarms within regulatory circles, emphasizing the precarious balancing act that market participants must navigate.