Since December, the bond market has experienced a significant rally, driven primarily by expectations of an interest rate cut from the central bankThis shift has resulted in the yield of the 10-year government bond dropping below 2%, reaching as low as 1.72% by early January 2025. Market participants are reacting to expectations that the central bank will cut rates by 30 to 40 basis points by 2025, reflecting a broader sentiment surrounding future monetary policy.

The initial catalyst for this downward trend in yields came at the end of November when a meeting was held to optimize self-regulatory mechanisms regarding interbank deposit ratesThis, coupled with new policies that eased liquidity and emphasized "moderately loose monetary policy" as a directive during a pivotal meeting on December 9, ignited investor enthusiasm, sparking a rush for government bonds

Investors have been grappling with subdued demand for physical financing and a supply of government bonds that is weaker than in previous years, contributing significantly to the prevailing “asset shortage.”

As we reflect on the bond market in 2024, it becomes evident that the overall trajectory has been bullishEven amidst caution from the central bank about potential risks and external economic factors, the prevailing trend remained steadfastThe timeline of bond market performance can be segmented into several distinct phases, each illustrating the dynamic interplay between monetary policy and investor sentiment.

The first phase spanned from the beginning of 2024 until early March, characterized by a continuous decline in the 10-year government bond yieldIn January, the regulatory focus was on preventing capital misallocation, leading to a contraction in asset supply and a clear “asset shortage” situation

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During this period, the yield fell from approximately 2.6% to around 2.3% by March, a decline of over 30 basis points.

From mid- March to the end of June, the market entered a phase of turbulenceAs yields hit lower levels, the central bank began signaling potential risks associated with long-term interest ratesBy April, regulatory bodies suspended various interest compensation mechanisms, tightening liquidity within deposit institutionsThis period saw the 10-year government bond yield fluctuate between 2.23% and 2.38% as investors weighed the implications of the shifting landscape.

The third phase occurred from early July to the end of September, during which a clear downward trajectory emerged driven by the central bank’s rate cutsThe situation culminated in an unexpected reduction of interest rates on July 22, which resulted in further declines across the interest rate curve

By mid-September, the yield on the 10-year government bond almost dipped to 2.0%.

In the latest phase from late September to the present, the market witnessed a notable correction following the announcement of a suite of supportive policies, including reserve requirement ratio cuts and interest rate reductions for existing mortgagesWith the equity market soaring in response—surging past the 3500-point mark on the Shanghai Composite Index before stabilizing around 3400—a readjustment unfolded in the bond marketHowever, after December 9, signals of a planned easing monetary environment again prompted a fresh wave of investment, pushing down the yields further post-2% threshold.

The underlying mechanics of government bond yields indicate that they both reflect the fundamentals of the economy—including growth rates, inflation, and policy adjustments—and are subject to the ebb and flow of supply and demand in the market

A key consideration has been the shifting risk appetite among investors, which has had immediate ramifications on yield movements.

Despite expectations for a relatively expansive policy approach by the end of September, a marked decline in risk appetite led to rapid gains within the equity market—a notable dichotomy in financial asset performanceThe influence of risk sentiment, observable in the swift ascent of equity values, momentarily altered the trajectory of government bond yields, prompting a modest rise.

Nonetheless, these considerations primarily impacted the bond market in the short term; the longer-term downtrend in yields has been predominantly driven by persistently low levels of inflation and a loosening monetary policy stance since late September.

Examining the relationship between government bond yields and price levels reveals that yields embody the nominal risk-free rate within the market

A surge in inflation would typically pressure yields upward; conversely, a prolonged period of subdued inflation fosters downward pressure on bond yieldsThe Consumer Price Index (CPI) for the first eleven months of 2024 reported a year-on-year increase of merely 0.3%, notably lower than the 1.4% average from 2020 to 2023.

From the perspective of supply and demand, the landscape has shifted significantly in recent monthsOn one hand, a decrease in the pace of local government bond issuance due to measures aimed at regulating debt has led to a contraction in high-yield assetsOn the other hand, changes to interest compensation mechanics and self-regulatory measures have redirected funds toward investment vehicles such as wealth management, money market funds, and bond funds, ultimately increasing their demand for bonds and reinforcing the ongoing “asset shortage.”

On the policy front, the meetings held on December 9 and between December 11-12 established a clear trajectory for monetary policy towards “moderate easing” for the upcoming year

This echoes similar sentiments from 2008 and 2009 when significant reductions in policy rates and reserve requirements were followed by a rebound in social financing and monetary supply growthThe recent central economic conference indicated a willingness to implement necessary rate cuts and maintain ample liquidity, thus prompting the initial rush towards bonds expected to yield higher returns in the future.

As we approach 2025, the question on many investors’ minds is how much of these anticipated cuts are already reflected in current bond yields.

A recent survey conducted by Huatai Securities among various investors—including banks, brokerages, mutual funds, insurance firms, and private equity—revealed that about half of participants expect the yield on 10-year government bonds to descend to 1.5% by 2025, with a general sentiment leaning towards a 40 basis point cut in interest rates.

In contrast to the fervent bond market, the equity markets have not mirrored these expectations with the same intensity

While the Shanghai Composite Index approached 3500 points on December 10, it quickly retreated to around the 3400 mark—a sign of a disconnection between how bonds and equities are pricing in future policy directions and broader economic fundamentals.

According to Huatai Securities, despite the momentum seen in the bond market, longer-term rates have already begun to reflect expectations of a 30 basis point cut, indicating that they have been priced in ahead of timeFor yields to break below current levels, a fresh catalyst would be necessaryWith dwindling protection from coupon rates, trading dynamics have gained importance, and any shift towards a trend reversal would require tangible signs of inflation resurgence and restabilized financing demands.

Similarly, Guosheng Securities highlighted that medium-term institutional adjustments may impose constraints on the downward movement of bond yields

The inversion of asset-liability ratios places pressures on the market—a factor to monitor closelyCurrently, banks have been issuing high-cost deposits while allocating resources to lower-yielding government debtOver the past month, net financing through bank certificates of deposit reached 1.3 trillion yuan, a stark contrast to just 230 billion yuan during the same period last year.

This is an indicative period for investment sentiment, as competitive rates for one-year AAA deposits are sitting at 1.63%, outpacing most mid-term government bond yields, raising concerns about the sustainability of positions held within government debtAdditionally, the banking sector has been under pressure to expand financial asset scales despite ongoing cost issues, while expectations of lessened demand for capital allocation post-year-end may impact the pace of bond buying.

Overall, the interplay of expectations surrounding monetary policy, inflation rates, and shifts in market sentiment will shape the movements in the bond market as we move into 2025 and beyond