M2 decline, LPR rate cut, and PBOC's "repeated warnings about bond market risks" - Understanding the current "monetary logic"

The latest financial data released this week has attracted much attention in the market, with both social financing and M2 experiencing declines, while the widening of the scissors gap has become a focal point.

What are the reasons behind this? After the release of social financing data, many institutions have conducted in-depth analyses on this, proposing different solutions based on understanding the current "monetary logic".

For example, in a research report released by Guotai Junan on June 15th, it mentioned that "if the LPR is not lowered in the short term, the best way to break this cycle is to control the long-term interest rate risk" and "the central bank's bond purchases can alleviate the continuous decline of M2".

Is there still room for LPR reduction? How to control the long-term interest rate risk? Will the bond market see a wave of positive news? Authoritative financial media have specifically analyzed these points, stating that against the backdrop of an overall decline in interest rates, the bond market has seen a long-awaited outbreak, but "the risks are not small", and investors should protect their "wallets"...

The current main monetary phenomenon: simultaneous decline in social financing and M2 + widening of the scissors gap

According to calculations by Wall Street News, the new social financing in May was 2.07 trillion yuan, continuing its downward trend; at the end of May, M2 grew by 7% year-on-year, a slight decrease from the previous 7.2%.

Guotai Junan stated that the reasons for the accelerated widening of the social financing-M2 scissors gap this time differ from before, with two specific reasons:

Looking at the trends of social financing and M2, the previous widening of the social financing-M2 scissors gap (such as in 2017 and 2020) was due to the growth rate of social financing being higher than that of M2. This was because of active corporate direct financing, which only increases social financing and does not change M2.

This round of scissors gap is caused by M2 falling more than social financing, and we believe two factors are dominant:

1. Government credit expansion while private credit contracts

2. Banks actively redeeming or reducing non-bank placements to mitigate the impact of deleveraging in the private sector

Regarding the "contraction of private credit", Guotai Junan believes that although government bond issuance supports social financing, there is also a need for an increase in private credit, otherwise the multiplier effect of fiscal injection will be weaker. The current situation is that after government bond issuance, residents' deposits are transformed into fiscal deposits (for example, residents purchase bonds from non-bank institutions through methods like wealth management), leading to a decrease in money supply and an increase in social financing.

In simple terms, after government bond issuance, funds circulate among banks, non-bank financial institutions, and residents.

In addition, Guotai Junan also emphasized the impact of private credit contraction on the behavior of commercial banks, that is, "the hedging behavior of banks for balance sheet contraction led to the widening of the scissor difference this time":

Factors such as early repayment acceleration and manual interest supplementation have triggered a "deposit migration", causing banks to actively redeem or reduce non-bank placements. This is reflected in the significant reduction of 2.2 trillion yuan in bank placements to non-banks in April, exceeding the seasonal 0.4 trillion yuan.

Bank placements to non-banks are not included in social financing, but the reduction in non-bank deposits implies M2 contraction, ultimately leading to the widening of the gap between social financing and M2.

How to Address the Continuous Decline of M2?

Guotai Junan stated that the decline in M2 can be alleviated through the methods of "stabilizing currency" and "shrinking the balance sheet", with "stabilizing currency" being the "central bank bond purchases" mentioned earlier:

Since the current monetary decline is caused by non-bank and household bond purchases, central bank bond purchases can to some extent intercept this path, weaken the bond purchases by non-banks and households, thereby slowing down the decline of M2. This is known as "stabilizing currency".

On the other hand, when the central bank normalizes bond purchases as a long-term monetary injection tool, from the perspective of the private sector, the imagination space for monetary easing opens up, inflation expectations rise, the deleveraging process may slow down or even reverse to credit expansion, and the pressure on banks to hedge balance sheet contraction will naturally ease. This is known as "shrinking the balance sheet".

Guotai Junan believes that stabilizing currency and shrinking the balance sheet complement each other, and may form a positive feedback loop:

Stabilizing currency itself can enhance inflation expectations, thereby slowing down the speed at which the private sector shrinks its balance sheet; and when the private sector slows down deleveraging, credit derivative mechanisms can stabilize the currency. We believe that central bank bond purchases may be the trigger for this positive feedback loop.

Is There Still Room for LPR Reduction? How to Control Long-term Interest Rate Risks?

The simultaneous decline of social financing and M2 is closely related to the current downward trend in long-term interest rates.

As mentioned in the research report by Guotai Junan, commercial banks (especially small and medium-sized banks) are now caught in a cycle of "declining long-term bond rates → accelerated early repayment (reloan at lower rates) → passive balance sheet contraction by banks (can only reduce loans)". There are two solutions to this issue, either lowering LPR in the short term, or controlling long-term interest rate risks.

Regarding LPR rate cuts, "China Securities Journal" quoted authoritative sources as saying that there is still room for interest rate cuts but they also face internal and external constraints. In fact, the central bank has publicly stated multiple times this year that there is still room for monetary policy, but the effects of previous policies are still emerging, and adjustments will continue to be made in response to changing circumstances. Objectively speaking, further interest rate cuts face internal and external "double constraints".

Regarding long-term interest rate risks, Guotai Junan believes that selling long-term bonds can help avoid more people repaying loans early due to the decline in long-term interest rates, thereby easing the pressure on banks to shrink their balance sheets In this context, the 5-year LPR is like a reference point for long-term bond rates. If the 5-year LPR can be kept around 2.5%, it may become a baseline for the 30-year national bond rate, which could reduce borrowers' motivation to repay early.

Regarding the specific operation of "selling bonds," Guotai Junan believes:

The central bank currently holds 1.5 trillion yuan of national bonds, accounting for 5% of the total national bonds, mainly in medium and short-term national bonds. Selling bonds may have limited control over long-term interest rates, but more in terms of signaling significance.

Authoritative media voices caution against bond market risks

Since discussing the possibility of interest rate declines, some market views have linked it to this year's hot national bond market.

This year, against the backdrop of overall declining interest rates, the national bond market has seen a long-awaited outbreak, especially with high trading volumes in long and ultra-long bonds. Benefiting from the bull market in the bond market, the returns of some bond funds have increased, with some products even achieving an annualized return rate of over 10%.

The significant fluctuations in the bond market have attracted widespread attention in the industry. Last Friday, the central bank's authoritative media "Financial Times" and one of the four major securities newspapers, "China Securities Journal," both published articles warning of bond market risks.

The "Financial Times" cited industry insiders as warning that there are many negative factors at present, but investors have either intentionally or unintentionally overlooked them. At this time, investors need to pay more attention to the price fluctuation risks of bond assets and safeguard their "wallets."

The "China Securities Journal" cited authoritative sources as saying that behind the bull market in bond funds lies considerable risks. "This round of bond fund market is closely related to the decline in bond rates, and this high yield is not sustainable."

This article combines the research report from Guotai Junan on June 15th, authored by Han Zhaohui (S0880523110001), Zhang Jianyu (S0880124030031), and Wang Hao (S0880521120002)