As the global economy transitions into the new fiscal year, early indicators reflect a less-than-optimistic outlook for the first quarter of 2023. Analysts and market observers are beginning to voice concerns about whether economic performance will meet expectationsHowever, with a limited supply of bonds in circulation, enthusiasm remains high within the bond market, making it a ripe area for investmentPredictions are suggesting a potential decrease in the yield of 10-year government bonds, possibly challenging the threshold of 2.30% as the quarter progresses.

Throughout the month of January, bond yields demonstrated a slow but steady declineYet, from late January onwards, a more pronounced downward trend began to emerge, culminating on February 5, when 10-year government bond yields plummeted to an unprecedented low of 2.40%. This marked not only a break from the previous low of 2.48% set on April 8, 2020, but also represented the lowest yield seen since June 19, 2002. In stark contrast, the shorter-term 1-year government bond yields experienced an even greater fall, down by a total of 24 basis points, settling at 1.88%.

Several factors can be attributed to this accelerated decline in bond yields:

Firstly, weaker-than-expected economic fundamentals are lending support to the bond market

During the fourth quarter of 2023, GDP growth was reported at 5.2%, falling short of the anticipated 5.4%. Coupled with a January manufacturing Purchasing Managers' Index (PMI) of 49.2%, which has been in contraction for four consecutive months, market sentiment toward the Chinese economy has soured significantly.

Secondly, the stock market is struggling, with the Shanghai Composite Index failing to hold above the 2800-point mark, thus escalating the market's risk-averse mindset and driving up demand for bondsOn January 22, the index dipped to 2735 points before experiencing a brief technical rebound, only to plummet further to a record low of 2635 points on February 5, a level not seen since March 19, 2020. The weak performance of the equity markets has left investors with a low risk appetite, consequently boosting the demand for bonds through an inverse relationship.

Thirdly, the central bank's surprising rate cut has fueled heightened expectations of further monetary easing

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On January 24, Central Bank Governor Pan Gongsheng announced an unexpected cut of 0.5 percentage points during a State Council press conferenceFollowing this announcement, on January 25, the central bank also lowered the interest rates for loans aimed at supporting small and agricultural businesses by 0.25 percentage points to 1.75%. This initiative signals a commitment to a looser monetary policy, prompting market expectations for a further 20 basis points reduction in policy rates, thereby igniting bullish sentiment in the bond market.

Additionally, the demand for bonds has surged against a backdrop of supply constraintsAt the beginning of the year, financial institutions adopted a “early investment, early returns” strategy, leading to vigorous trading and investment demand in the bond marketHowever, the net supply of rate bonds dropped significantly compared to December 2023, plunging by 560.1 billion yuan to just 406.6 billion yuan, creating a situation in which demand outstripped supply, consequently resulting in lower bond yields.

Looking ahead, the future trajectory of the bond market hinges heavily on economic and financial data that can influence market sentiment

Many economic indicators are scheduled for release in March, summarizing the data from January and FebruaryIt’s anticipated that persistently weak fundamentals will continue to underpin the bond market.

Furthermore, fluctuations in liquidity will also impact investors' willingness to leverage their positions in the bond sectorOn February 5, an influx of funds totaling 1 trillion yuan from the reserve rate cut will arrive, combined with an additional 500 billion yuan injected through the PSL (Pledged Supplementary Lending) in the prior two monthsThis liquidity should help alleviate the cash withdrawal demand typical around the Lunar New Year, limiting the extent to which funding rates rise and further supporting the bond marketHowever, post-holiday, a potential acceleration in government bond issuance might tighten liquidity margins, prompting investors to tread cautiously when leveraging their positions.

Market participants will also be looking for insights from the upcoming monetary policy decisions on February 18 concerning the Medium-term Lending Facility (MLF). With 499 billion yuan worth of MLF maturing in February, investors expect a modest extension of the MLF, although it is likely that the interest rate will remain unchanged, potentially jeopardizing expectations for a broader interest rate cut

Given the backdrop of underlying economic weakness, the market may defer its anticipations for interest rate cuts, which would limit the degree of yield increases on bonds.

Moreover, the bond market is intrinsically tied to the performance of the stock marketShould the equity markets remain subdued, the demand for bonds, particularly from trading organizations, is likely to remain robust, suggesting there is still further room for bond yields to decreaseHowever, if effective measures are taken to stabilize the stock market, including the establishment of a stabilizing fund, we may see a modest improvement in market risk appetite, potentially driving a short-term rebound in bond yields.

Finally, investors are eagerly anticipating policy announcements from the coming Two Sessions in March

A key focus of these sessions will be the targeted fiscal deficit rate, which will ultimately clarify the overall supply of government bonds and its potential implications for the bond market.

As bond yields have plunged to levels not witnessed in nearly 22 years, bolstered by a considerable accumulation of profit-taking positions, it is crucial for the market to experience a period of stabilization and adjustmentGiven that economic data performance may frequently underdeliver against expectations during the first quarter, combined with limited bond supply and a strong demand sentiment within the market, negative news will only cause short-term disturbances without fundamentally altering the prevailing bullish outlook on bondsTherefore, it is reasonable to expect that the yields on 10-year government bonds may indeed challenge the 2.30% threshold in the first quarter.