The recent surge in AI investment, particularly driven by companies like DeepSeek, has reinvigorated the stock markets in China, specifically in the A-shares and Hong Kong marketsAs investor sentiment shifts dramatically, the balancing act between stock and bond markets, often referred to as the "see-saw effect," has intensified.

As of February 25th, the yield on 30-year government bonds has rebounded from a near-record low of around 1.8% to 1.9025%. Meanwhile, the yield on 10-year government bonds has similarly increased from about 1.6% to 1.7175%. Such yield changes have contributed significantly to the inversion of short-term and long-term financing rates, which is a key concern for bond markets.

This inversion indicates a puzzling scenario where borrowing for one day is more expensive than borrowing for one month, and even longer durations like a yearOn February 25th, the rates for DR001 and DR007 were reported at 1.8686% and 2.2161%, respectivelyThough these rates have receded from previous highs, they continue to overshadow long-term government bond yields significantly.

“We anticipate increased volatility in the bond market due to tightening credit conditionsThe weak performance of traditional sectors like construction and commoditized goods means fundamentals have less impact on the bond market’s outlookHowever, the primary negative pressure stems from tight liquidity, which is altering market expectations regarding interest rate cuts and prompting institutions to lower their leverage,” commented Wang Qiang Song, head of research at Nan Yin Wealth Management.

On the contrary, it has been noted that financial institutions have expanded their scale rapidly over the past yearThis means that despite the challenges, they are still experiencing robust profitability in the bond market, combined with stricter risk controls which cushion them against immediate pressuresConsequently, as market volatility rises, institutions may prefer to manage long-term bond holdings meticulously while seeking higher relative value in mid to short-term bonds.

The ongoing inversion of interest rates has indeed prompted many institutional investors to shorten the duration of their holdings.

With the recent positive momentum in the stock market, investors have shown an overall inclination towards higher risk

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This, along with a persistently tight financial environment, has driven a cautious attitude towards Chinese bond marketsInvestors are now more focused on decreasing their positions and reducing leverage, with a shift towards spot trading and relative value preferencesThis shift also reflects a slight uptick in bearish sentiment towards bonds.

The AI boom has propelled the Shanghai Composite Index to near the 3400-point mark, while the Hang Seng Tech Index surged nearly 30% this yearFurthermore, southern funds have been pouring into Hong Kong stocks, achieving a record 48 consecutive weeks of net inflows.

This changing dynamic of relative value between stocks and bonds has led to capital flowing out of the bond marketWu Zhaoyin, the chief investment officer at Dongwu Futures, pointed out that the yield on one-year government bonds dropped from around 2.4% at the end of last year to 1.4% nowConcurrently, the annualized yield of Yu'ebao also fell from 2.43% to 1.4%, while post-tax dividend yields from listed companies have reached 2.9%. This gap significantly surpasses both the bond yield and Yu'ebao returns.

The more significant factor affecting the bond market remains the inversion of short and long-term yields, which has constrained bonds' performance since the start of the year.

While the interbank funding gap was not substantial in February, the central bank's persistent tightening measures thwarted expectations for easingAs a result, the yield and cost of capital continued to exacerbate the inversion, leading to strong sell-off sentiments at the beginning of the weekObservers are advised to keep an eye on the potential for market adjustments triggered by bond redemptions and further decreases in liquidity.

On February 25th, the financial landscape in the morning appeared tight yet began to ease in the afternoonThe short-term interbank funding rates saw a slight drop, but costs for inter-month funds remain highThe overnight weighted average rate stood near 1.87%, while the seven-day rate rebounded by 16 basis points to 2.2162%. Both 6-month and 1-year time deposit rates continue to show an inversion, with the weighted issuance rate for one-year government bonds slightly rising around 3 basis points to between 1.97% and 1.99%.

In this environment, last year's favored strategy of increasing bond duration is dwindling in viability

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The selling of ultra-long bonds has intensified, and institutions are being compelled to reduce leverageData indicates that last week, funds reduced bond holdings by 139.2 billion yuan, mainly targeting medium and long-duration government bondsBrokerages cut back 105.1 billion yuan, primarily offloading rate bonds and certificates of deposit, while trading funds notably reduced their durationNevertheless, some institutions chose to buy into long-duration bonds when prices elevated, such as rural financial institutions purchasing 265.8 billion yuan primarily in long-bond ratesInsurance firms added 104.6 billion yuan, predominantly in long-duration bonds, and wealth management entities maintained steady purchasing at around 35.8 billion yuan.

Expectations concerning interest rate cuts have also softened recently, leading to a dip in bond market sentiment.

The central bank's recent report regarding its monetary policy execution for the fourth quarter of 2024 highlighted several points of concernLian Ping, chief economist at Guangwai First Industry Research Institute, noted that external factors are increasingly negatively impacting China's economic stabilityThe Federal Reserve's slower pace of interest rate cuts exerts adverse spillover effects on China, increasing uncertainties and making it challenging for China’s monetary policy to lower rates while supporting the renminbi’s stability.

Simultaneously, some signs of stabilization are emerging within the Chinese economy, amplifying the pressure on the bond market to take corrective actions.

During the recent Spring Festival, heightened entertainment demand due to an extended holiday resulted in a significant rise in domestic tourism—daily tourism income increased by 15% compared to 2019 levels, while box office revenue peaked with hits like "Ne Zha 2," grossing over 12 billion yuanThe real estate sector, after two years of downward adjustment, is showing signs of stabilization.

However, economic indicators remain mixed

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Wang Qiang Song pointed out seasonal declines in food prices, weak export demand, and lagging construction activity, as research indicates a decrease in construction site earnings rates, cement, and rebar pricesIt’s noteworthy that while new home transactions in 30 cities have weakened, second-hand homes continue to show significant growth year-on-year, with top-tier cities experiencing a stabilizing trend in housing pricesIndicators remain murky as there is a blend of positive and negative data during this transitional periodThe traditional economic sectors such as construction and real estate still require policy support, while emerging fields tied to technology—such as AI and robotics—are indicating signs of growth, showcasing a stark contrast in economic vitalityDespite a recovery in confidence regarding economic prospects, there remain uncertainties tied to trade and international relations.

On the policy front, local governments are leveraging special bonds to acquire land, which is expected to enhance funding flows for urban investment and real estate firms, thus mitigating land inventory pressures and improving supply-demand dynamics in the real estate marketHowever, market attention is predominantly focused on the implications of the upcoming symposium for private enterprises, anticipated policy support, and Alibaba's unexpectedly strong earnings report, which could catalyze expanded capacity in the tech sector.

Across the board, there is consensus that stimulus policies are essentialSong Yu, chief economist at BlackRock's China division, pointed out, “We expect more supportive measures for private enterprises and foreign investments to emerge around the Two Sessions, especially with growing backing for real estate and international firmsImmediate action will optimize usage of available policy spaceCurrently, market expectations surrounding the Two Sessions are low, meaning any policy support that exceeds expectations can yield disproportionately beneficial outcomes.”

Maintaining volatility at a high level, the bond market’s mid to long-term trajectory is under debate, yet the consensus appears to lean towards sustained short-term fluctuations.

CITIC Securities stated that with the yield curve for government bonds in a bear flattening state, they anticipate near-term potential for a yield curve rebound and heightened risks for the long and ultra-long ends of the curve, with the 10-year bond yield ceiling likely around 1.8%.

It's important to note the significant impact of negative spillover effects from the offshore market

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