In recent times, Chinese A-shares and Hong Kong stocks have seen a significant surge, fueled primarily by the growing excitement around AI investments like DeepSeekThis uptick in the equity markets has intensified the “stock-bond seesaw effect,” where movements in one market affect the otherAs of February 25, market participants observed a rise in the yield on 30-year government bonds, which recovered from its previous low around 1.8% to 1.9025%. Similarly, the yield on 10-year bonds increased from approximately 1.6% to 1.7175%. This scenario depicts a reversal in the yield curve, highlighting a critical phenomenon in the bond market.

To illustrate, the rates for borrowing money for one day have inexplicably surpassed the costs of borrowing for one month or one yearOn February 25, the overnight and seven-day interbank lending rates, reported at 1.8686% and 2.2161% respectively, indicate that despite a slight pullback from earlier peaks, they remain considerably above the long-term government bond yields.

Wang Qiang Song, head of the research department at Nanyin Asset Management, expressed to Yicai Finance that upcoming volatility in the bond market is anticipated to increaseHe pointed out that sectors of the old economy, particularly construction and the prices of related commodities, are currently subdued, leading to a limited impact on the fundamentals affecting the bond marketThe core negative pressure on bonds stems from a tighter liquidity environment; persistently high rates have altered market expectations regarding interest rate cuts and led institutions to reduce their leverage

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Concurrently, trading funds are also taking action to decrease duration, while the market starts to focus on issues like the redemption of bond funds.

Nevertheless, sources close to the investment community state that due to rapid growth in asset management subsidiaries over the past year and despite strong profitability in the bond market, pressures are perceived to be manageableLooking ahead in a more volatile environment, institutions are opting to control positions in long-duration bondsAs the bond yield curve flattens, the relative value of mid-to-short-term bonds becomes more appealing.

As the stock market strengthens, notably driven by heightened investor risk appetite, liquidity continues to remain in a state of balanceThis shift has led investors to adopt a cautious stance on the Chinese bond market, characterized by reduced duration and leverage, along with a preference for swing trading based on relative valueInterestingly, those anticipating bearish trends in the bond market have slightly increased.

Alongside the excitement surrounding AI innovations, the Shanghai Composite Index approached the 3400-point mark, while the Hang Seng Tech Index recorded an impressive nearly 30% increase this year aloneSouthbound capital has been pouring into Hong Kong stocks consistently, showcasing net inflows for 48 consecutive weeks up until last week.

The shift in the relative value between equities and bonds has initiated capital outflows from the bond market

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Wu Zhaoyin, Chief Investment Officer at Dongwu Futures, indicated to Yicai Finance that the one-year bond yield has dropped from around 2.4% at the end of last year to approximately 1.4% recentlyConcurrently, the annualized yield on Yu’ebao has also fallen to 1.4%, while listed companies now offer a post-tax dividend yield of 2.9%, which markedly surpasses both the one-year bond yield and Yu’ebao return.

Yet, the most significant factor affecting the bond market continues to be the inversion of short and long-term yieldsSince the start of the year, a persistently tight liquidity environment has restricted the so-called “bull market for bonds.”

According to Jianxin Futures, although the static gap in the interbank market was modest in February, the central bank's ongoing efforts to tighten liquidity have impeded the anticipated easingThis has exacerbated the inversion of bond yields and funding costs furtherAt the beginning of this week, the strong sentiment to cut losses was noted, and participants must pay heed to the potential negative feedback loop of bond market declines, redemption of wealth management products, and subsequent market adjustments.

On February 25th, the liquidity in the morning session was tight but gradually eased in the afternoonShort-term interbank rates dipped, although cross-month liquidity remained high cost-wiseThe overnight weighted average in the interbank market has been fluctuating around 1.87%, while the seven-day rate rose by 16 basis points to 2.2162%. Notably, rates on certificates of deposit for both six months and a year remain inverted, with the one-year interbank issuance rate climbing slightly by around 3 basis points to between 1.97% and 1.99%.

In light of this context, the popular strategy from last year, "increasing duration," appears to have come to an end

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The selling pressure on ultra-long bonds has intensified, forcing institutions to reduce leverageRecent data reveals that during the last week, funds shed 139.2 billion yuan in bonds, predominantly focusing on medium to long-duration instruments, while brokerage firms disposed of 105.1 billion yuan, mainly in interest rate bonds and certificates of deposit, indicating a clear trend towards shortening durations within trading-class fundsHowever, some institutions have continued to increase their long-duration holdings, such as rural financing institutions, which purchased 265.8 billion yuan and mainly augmented their long-term interest rate bondsInsurers have also been active, buying 104.6 billion yuan predominantly in long-term interest rate debt, while wealth management remained relatively stable with a slight increase of 35.8 billion yuan.

Currently, cooling expectations for interest rate cuts are contributing to a weakening sentiment in the bond marketThe People's Bank of China recently published its monetary policy implementation report for the fourth quarter of 2024. Lian Ping, Chief Economist at the Guangfa Chief Industrial Institute, pointed out that one of the report's highlights includes an acknowledgment of increased adverse impacts brought about by shifts in the external environmentThe pace of interest rate reductions by the U.SFederal Reserve and other factors have unfavorable spillover effects on China’s steady growth, and rising uncertainties may complicate the ease of China's monetary policy, especially regarding lowering interest rates and stabilizing the yuan.

Furthermore, signs of stabilization within the Chinese economy are surfacing, albeit causing additional downward pressure on the bond market

Yet high-frequency economic data remains mixedWang Qiang Song noted that, in terms of inflation, food prices are experiencing seasonal declines; in terms of exports, demand is weak along with falling shipping pricesConstruction activity appears tepid, with surveys highlighting declines in construction site resumption rates, funding availability, and labor engagement ratesNotably, prices for cement and rebar have also droppedWithin the real estate sector, transactions of new homes in 30 cities are uninspiring, while the secondary market is experiencing significant growth year-on-year, revealing a stabilization trend in housing prices in leading citiesAmidst the absence of new economic data, mixed signals emerge from high-frequency indicators, complicating the formation of a clear trendThe older sectors of the economy, particularly construction and real estate, still require policy support, whereas fields tied to technology, such as AI and robotics, are displaying signs of expansionThis divergence between new and old economic forces underscores a revival of market confidence; nonetheless, trade and international relations present ongoing uncertainties.

On the policy front, regions including Beijing and Guangdong are utilizing special bonds to absorb land, which may assist in improving the capital flows for urban investing and real estate companies while reducing market land inventoryThis action could potentially enhance supply-demand conditions in the housing marketIf the issuance of special bonds for land acquisition increases, it could alleviate the oversupply situation in the real estate sectorMoreover, heightened market attention surrounds private enterprise symposiums, policy support, and better-than-expected results from major firms like Alibaba, which could prompt further capacity expansion in the tech domain.

There is a prevalent belief among various sectors that stimulus policies are essential

Song Yu, Chief Economist at BlackRock's China Institute, communicated to Yicai Finance that more policies supporting private enterprises and foreign investments, particularly targeting real estate and foreign companies, are expected to be unveiled around the time of the National People's CongressIt is crucial to leverage the current policy space effectively and, with market expectations about the upcoming congress being low, unexpected supportive measures could yield significant benefits.

In conclusion, while the bond market appears to maintain elevated volatility levels, there are divergent outlooks regarding its mid-to-long-term trends; the consensus indicates that short-term fluctuations will remain persistently high.

CITIC Securities reports that the current yield curve of government bonds is in a bearish flat state, and looking ahead, there is still a risk of rebound in the yield curve in the short termAdditionally, the risk of corrections in the long end and ultra-long end cannot be overlooked, with the upper limit for the 10-year government bond yield potentially resting at 1.8%.

It is significant to highlight that negative spillover effects from the offshore market are also pronouncedZhang Meng, a macro and forex strategist at Barclays, indicated that in January and early February, the People's Bank of China tightened offshore renminbi liquidity to suppress bearish positions on the offshore yuan, exposing investors to substantial negative interest spreads during routine valuation sessionsDuring periods of strengthening U.S. dollar, the tightening of offshore liquidity often exceeds that of the onshore market.

Wu Zhaoyin conveyed to Yicai Finance that this rotation of capital is expected to continue. "Over the past thirty years, the occurrence of bull markets in the stock market has been more likely during periods of economic downturn

In such times, there is greater monetary supply with lower inflation and subdued economic growth, leading to substantial funds flowing into capital markets."

From a macro asset rotation perspective, in a complete cycle, funds typically transition from lower-risk assets to higher-risk variants; the rough trajectory follows the order of: currency (including quasi-currency assets) → bonds (with internal order being interest rate bonds, municipal bonds, corporate bonds, convertible bonds) → stocks (starting with undervalued varieties and progressing to overvalued ones) → commodities → currenciesThe current shift has commenced, with 2022 being characterized by currency weakness across stocks, bonds, and commodities, and 2023 has marked a rebound in bonds, while stocks are expected to follow next.

Additionally, some experts believe there will still be opportunities in the bond marketFor instance, China International Capital Corporation stated that ongoing fundamental recovery continues to face challenges from increasing uncertainties stemming from both domestic and international environments, which does not support a significant adjustment in boundsThe core support for a favorable bond market remains unchanged in the year, and while short-term volatility may be temporary rather than indicative of a trend, results from their recent bond market survey revealed that as much as 90% of investors believe rates will pivot back down within this year.