Three "disappearances" reflect new changes in the bond market

Currently, the bond market is undergoing a series of significant changes: the phenomenon of fund stratification is gradually disappearing; the low DR007 rate is no longer common; and the once prevalent "roll overnight" in the bond market is also gradually decreasing.

Analysts believe that behind these changes is the market's response to the central bank's monetary policy operations, as well as a reassessment of the funding and interest rate trends. These phenomena indicate that both banks and non-bank financial institutions are facing structural changes in their liabilities and liquidity environment, reflecting the central bank's policy intentions to maintain financial market stability, prevent fund idling, and arbitrage activities.

Near Disappearance of Fund Stratification

Normally, there is a significant liquidity stratification effect in the fund market. This is because the funds injected by the central bank first flow to primary dealers dominated by national large banks, then to city and rural commercial banks, and finally to non-bank financial institutions. This results in downstream institutions bearing higher funding costs, leading to liquidity stratification. The main measure of this effect is the difference between the weighted average interest rates of the interbank 7-day pledged repo (R007) and the deposit-type institution 7-day pledged repo (DR007). Since DR007 mainly reflects interbank financing costs, while R007 includes non-bank financial institutions' financing costs, the larger the difference between R007 and DR007, the higher the financing costs for non-bank financial institutions, and the more prominent the liquidity stratification.

Since the beginning of this year, the phenomenon of fund stratification in the bond market has gradually weakened. After entering the second quarter, the interest rate spread between non-bank financial institutions and interbank financing funds continued to shrink and even inverted at one point.

A recent observation by a reporter from the Shanghai Securities Journal found that the stratification of funds between institutions has nearly disappeared. According to the reporter's statistics, in April, the daily average interest rate difference between R007 and DR007 quickly narrowed to 8.61 basis points, further narrowing to 2.54 basis points in May, and remained at a relatively low level in the first half of June. The phenomenon of liquidity stratification has nearly disappeared, while in the first quarter, the daily average interest rate difference between R007 and DR007 was still 25.91 basis points.

In response to this, analysts believe that the near disappearance of fund stratification reflects the result of deposit funds exiting, a significant increase in wealth management scale, and deleveraging in the bond market, indicating that both banks and non-bank financial institutions are facing structural changes in their liabilities and liquidity environment.

Lin Canhong, from the Fixed Income Investment Team at Guosen Securities Asset Management Headquarters, believes that the reduction in deposit rates and the cessation of "manual interest supplementation" have led to a decrease in liquidity within the banking system, reducing fund outflows correspondingly, keeping interbank financing rates high; while the phenomenon of "deposit relocation" has significantly increased the scale of non-bank financial institutions, the failure of leverage arbitrage strategies has reduced the demand for funds by institutions, bringing non-bank financial institution financing rates closer to interbank financing rates.

Wang Defa, a researcher at Changshu Rural Commercial Bank, stated that the portion of deposits previously obtained through "manual interest supplementation" to attract high interest rates will seek alternative financial products, resulting in a gradual shift of these funds from bank deposits to low-risk products such as money market funds and bank wealth management products "Part of the funds have been transferred from bank deposits to non-bank financial products such as bank wealth management, which means that the funds have completed a fund transfer without going through the interbank market. This has also led to a decrease in the funding needs of non-bank financial institutions, resulting in a significant decline in R007, and the hierarchical phenomenon between R007 and DR007 has weakened," said Wang Defa.

In addition, as some asset yields rapidly approach the interest rate, causing the leverage arbitrage space of non-bank financial institutions to shrink, the funding demand decreases, and money market funds and wealth management products also begin to increase repurchase lending. Lin Canhong stated that since the implementation of the "comprehensive debt-to-equity swap" policy, the central credit spread has continuously moved downward, various asset yields have decreased significantly, and the high-yield strategy has become ineffective; the space for institutional leverage arbitrage has narrowed, thereby reducing the demand for reverse repurchase funds.

Disappearance of Low DR007 Rates

The second noteworthy phenomenon is that the previous common occurrence of market rates lower than policy rates has disappeared.

Former Deputy Governor of the central bank, Liu Guoqiang, once stated at a press conference that the central bank uses the price fluctuations of DR007 as an indicator to observe whether the interbank market liquidity is sufficient. Therefore, DR007 generally does not deviate significantly from the policy rate, but fluctuates around the policy rate. Several traders also told reporters that when market rates are higher than the policy rate, the central bank will consider the interbank market liquidity to be tight and will increase liquidity injection to stabilize price fluctuations; when market rates are lower than the policy rate, the central bank will consider the interbank market liquidity to be sufficient and will reduce net injections or even net withdrawals.

However, since the beginning of this year, the central DR007 rate has basically remained slightly above the 7-day reverse repurchase rate level with narrow fluctuations. Industry insiders believe that when DR007 continues to be higher than the 7-day reverse repurchase rate and the central bank continues to inject funds in small amounts, it may reflect its policy intentions.

First, it balances interest rates and exchange rates. A foreign exchange analyst explained to reporters that the interest rate cuts by European and American central banks will strengthen the US dollar index, increasing pressure on the RMB exchange rate. Earlier, the Bank of Canada and the European Central Bank had already started the interest rate cut cycle, but the Fed's interest rate cut expectations are still far away in December, with a significant time difference.

"Due to the high weight of the euro in the US dollar index, the time difference in interest rate cuts has led to the strengthening of the US dollar index, increasing short-term pressure on the RMB exchange rate. In the background of the unclear Fed interest rate cut expectations and the potential upward risk of US bond yields, maintaining relatively high fund and short-term bond rates will help alleviate the pressure on the RMB exchange rate," the above-mentioned person said.

Second, it prevents idle funds and arbitrage. In theory, when the fund rate is below the reverse repurchase rate, financial institutions are more willing to borrow lower-cost market funds through interbank lending rather than borrowing from the central bank's reverse repurchase for financing. This may lead to a decrease in the central bank's control over the liquidity, with the risk of idle funds. Therefore, Jin Yi, Chief Analyst of Fixed Income at Guohai Securities, stated that when the fund rate is above the reverse repurchase rate, the central bank can adjust the scale of reverse repurchase injections to enhance fund control accuracy and prevent idle funds The People's Bank of China released the first quarter of 2024 report on the implementation of China's monetary policy on May 10, also stating the need to ensure the smooth transmission of monetary policy and avoid idle funds.

"Against the backdrop of preventing idleness, the People's Bank of China is unlikely to guide market interest rates below policy rates by increasing monetary injections, unless the increase in real financing demand leads to market liquidity stress," said Wang Defa.

In addition, the liquidity and cost of liabilities of commercial banks themselves are also important reasons. Wang Defa believes that since last year, the growth rate of M2 has continued to decline, and this year, the growth rate of M2 has started to fall below the growth rate of social financing, leading to a relative tightening of macro liquidity; at the same time, due to factors such as the regularization of deposits, the decline in deposit costs is limited, resulting in a limited decrease in the overall liability costs of banks, which to some extent has created resistance to the downward movement of DR007.

The Disappearance of "Rolling Overnight"

Currently, the once popular phenomenon of "rolling overnight" in the bond market has gradually disappeared.

"The scale of pledged repo transactions, which used to reach nearly 8 trillion yuan, is now rarely seen. Recently, the transaction volume has been around 6 trillion yuan, and at the end of the month, it can even drop to 3 trillion yuan," said a fund trader. On June 14, the interbank market's pledged repo transaction volume was 6.6 trillion yuan.

The significant shrinkage of pledged repo transactions is the result of the waning popularity of the bond investment strategy of "rolling overnight." According to Wang Defa, the application of the "rolling overnight" strategy has prerequisites: first, the asset-side returns provide good protection against fluctuations in the cost of leveraged liabilities; second, there is ample liquidity, and the probability of institutions being forced to sell assets to cover liquidity shortfalls when using this strategy is small. Currently, the first condition is not met because the protection of asset-side returns against the cost of liabilities is insufficient.

The asset-side returns mainly include two aspects, namely coupon income and capital gains.

Firstly, the current spread protection for coupon income is clearly insufficient. According to statistics, the monthly average of overnight funding rates (DR001) has been between 1.69% and 1.76% this year, while the monthly average of 1-year government bond yields has been between 1.62% and 2.07%. Excluding tax considerations, since April, the 1-year government bond yield has been lower than DR001.

Even if the asset maturity is extended and the maturity mismatch is increased, looking at the difference between the 3-year government bond yield and DR001, the average from 2022 to 2023 was about 85.42 basis points, while this year it has only been 34.56 basis points on average, dropping further to 21.85 basis points since the second quarter, significantly reducing the protection of spread against liability price fluctuations.

Secondly, the narrowing of term spreads and the difficulty in smooth interest rate declines have made it harder to obtain capital gains, making the "rolling overnight" strategy less effective. "Overall, it is difficult for the interest rate curve to shift downward. In this context, it is challenging to protect liability price fluctuations through capital gains," said Wang Defa.