The analysis of historical data reveals an intriguing trend in the realms of bond pricing in ChinaSpecifically, it suggests that the 7-day reverse repurchase rate (reverse repo rate) serves as the primary anchor for the pricing of 10-year government bonds, rather than the 1-year medium-term lending facility (MLF) interest rateThis reorientation is particularly noteworthy against the backdrop of the ongoing bond market bull run in 2024.

Starting from January 9, 2024, the yield on 10-year government bonds dipped below the previously significant benchmark of 2.50%, marking the MLF rateThis decline represented a new low not seen since April 26, 2002, with the MLF rate's role in pricing diminishingThe People's Bank of China (PBOC) has since emphasized a shift towards viewing the 7-day reverse repo rate as the primary policy rate, further recalibrating market expectations

This new trajectory raises questions about the future pricing mechanism for 10-year government bonds.

To illustrate how the relationship between government bonds and MLF has evolved, a closer examination of historical trends reveals critical insightsSince 2016, the monthly average of 10-year government bond yields has generally oscillated around the 1-year MLF rate, showing a positive spread in periods where yields exceeded the MLF rate and a negative correlation when below itOver this stretch of time, 10-year government bonds have demonstrated a complex yet stable relationship with the MLF rate, highlighting the latter's role as a pivotal benchmark.

Interestingly, there have been distinct phases in this relationshipFor instance, from May 2017 to June 2018, the spread between the 10-year government bond yield and the MLF rate occasionally surpassed 30 basis points (BP), reaching peaks of up to 72 BP

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However, as time went on, these differentials began to stabilize, with yields falling into narrower ranges closely aligned with MLF ratesSince July 2018, there has been a remarkable consistency where the average yield on 10-year government bonds has largely remained within ±30 basis points of the MLF, reinforcing the notion of the MLF rate as a significant pricing anchor during that period.

Additionally, data from the past few years indicates a noteworthy synergy between government bonds and the yield on 1-year AAA-rated interbank certificates of deposit (CDs), particularly after July 2018. CDs, known for their higher frequency of yield fluctuations compared to MLF rates, have a profound impact on government bond metrics due to their relevance in capital allocationThe dynamics between these instruments reveal the intricate web of relationships in the monetary landscape and signal the importance of market rates in shaping bond pricing.

The correlation between the yields on various financial instruments extends beyond a mere numerical relationship; it illustrates a broader narrative of market expectations and behaviors

For instance, the dynamics between 1-year government bonds and R007 (a short-term funding rate) as well as DR007 further elucidate this interdependenceThe flows of liquidity within financial systems are affected significantly by the movements of these short-term interest rates, as well as the policies of the PBOC.

In this context, it's particularly instructive to consider the implications of the changing interest rates on bond yieldsFor example, while the yields on 1-year government bonds show a tendency to align closely with prevailing short-term rates, the correlation remains robust even when examining yields on longer duration bonds like the 10-yearPost-July 2018, it became increasingly evident that the 1-year government bond yield appears to fluctuate closely around the 7-day reverse repo rate, confirming its place as a significant pricing reference

The evolving relationships point to a shift wherein the 7-day reverse repo rate acts as a linchpin for pricing mechanisms in the longer-duration segment.

In order to assess the true pricing anchor for government bonds, a correlation analysis was performed for various interest ratesThe findings were revealing; specifically, the correlation coefficient between the 1-year government bond yield and the 7-day reverse repo rate reached 71%, surpassing the 68% correlation with the MLF rateThe correlation for the 10-year bond yield with the 7-day reverse repo was even more pronounced at 82%, again overshadowing the 79% correlation with the MLF rateThese statistics substantiate the hypothesis that the 7-day reverse repo rate outstrips the MLF rate as a reliable benchmark for bond pricing.

Sampling within the specified temporal framework also indicated that the average yield disparity between 10-year government bonds and the 7-day reverse repo rate was approximately 80 basis points

Conversely, the average difference between 1-year government bonds and the 7-day reverse repo rate was found to be 19 basis pointsFrom this, one could assert that the long-term pricing baseline for 10-year government bonds rests around “7-day reverse repo rate + 80 BP” while the 1-year variant orients itself around “7-day reverse repo rate + 20 BP,” suggesting a reasonable premium for extending maturities.

Assessing the angular relationship between “7-day reverse repo rate + 80 BP” and “1-year MLF rate + 5 BP” yielded acid tests for their comparative efficacy as pricing normsCalculating the squared error sums for the monthly averages of yields against these benchmarks over the sample period indicated that the yield errors against the “7-day reverse repo rate + 80 BP” were markedly lower than those against the “1-year MLF rate + 5 BP”. Such numerical evidence fortifies the premise that, in light of recent monetary policy adjustments emphasizing the reverse repo rate, market participants should recalibrate their expectations concerning bond pricing.

Furthermore, as of the end of July 2024, the 10-year government bond yield settled at an unprecedented low of 2.15%, significantly below the long established pricing benchmarks

With just 45 BP separating it from the 7-day reverse repo rate, we observe a clear deviation from historical pricing normsMeanwhile, the 1-year government bond yield at 1.42% notably drifted beneath the reverse repo rate, suggesting a growing disconnect between traditional pricing references and current market realities.

This departure from established pricing baselines can somewhat be attributed to an ongoing phenomenon dubbed "asset scarcity." A persistently weak demand for financing in the real economy has played a critical role in propelling bond yield declinesThis is underscored by a marked reduction in the incremental increase in social financing, which had fallen by 3.14 trillion yuan year-on-year by the end of June 2024.

It is crucial to note that the current environment is characterized by a significant mismatch between available investment assets and financing demand across various sectors

With the majority of newly created incremental credit stemming from bank loans, there has been notable growth in the total scale of bonds held by banks, indicative of a robust demand for such instruments amidst a backdrop of diminishing supply.

Additionally, changes in regulatory environments surrounding financial asset management have catalyzed movements of deposits into bank-managed investment products, leading to substantial growth in the asset management industryAs of June 2024, the holding scale of bonds by these funds surged to 48.38 trillion yuan, reflecting a shift in how capital is allocated across financial instruments.

Financial institutions are finding themselves in a liquidity-rich environment, grappling with the pressures of asset allocation while simultaneously contending with a limited supply of investment opportunities

This has created a scenario where vast pools of capital chase a dwindling number of assets, thereby perpetuating the downward spiral of bond yieldsExtending durations on government bonds has emerged as an attractive strategy for generating larger spread revenues, exacerbating the downward push on the yields of both 10-year and 30-year assets.

Despite the proximity of bond yields to the reverse repo rate, the latter's rate adjustments display a relatively slower pace compared to other market ratesNotably, the yield on 1-year interbank CDs shows a stronger correlation with both the 1-year and 10-year treasury yields, underscoring the critical role of this instrument in the pricing landscapeConsidering that banks accounted for a substantial portion of government bond holdings, if interbank CD rates continue to decline, it stands to reason that government bond yields would likely follow suit