In recent days, the bond market has experienced a notable adjustment, particularly with the TL2503 bond, which has dropped below its 20-day moving averageThis shift can be primarily attributed to the tightening liquidity conditions, evidenced by the one-year deposit certificate interest rate climbing to around 1.9%. As a result, many observers question the underlying economic factors at play, with some boldly asserting that the prevailing sentiments regarding “interest rate hikes stimulating consumption” are fundamentally flawed, flipping the cause-and-effect narrative.

Interestingly, domestic investors appear to be influenced by a 'RMB lens', which clouds their judgment of monetary policy, causing them to resist the central bank's trendsThey maintain a steadfast belief that the central bank will ultimately loosen liquidity, regardless of the immediate tightening measuresThis dynamic has led to a significant inversion in the yield differential between the ten-year government bonds and the one-year deposit certificates, with the inversion recently spiking to 14 basis points – the highest in several yearsThis phenomenon underscores a significant divergence between the central bank's perspective and that of domestic financial institutions, with the latter arguing that the current tightening is unreasonable given the state of the domestic economy.

This raises important questions:
1. Can the domestic investors, relying on collective strategies, withstand the tightening of liquidity?
2. If the central bank believes that the current ten-year bond yields do not reflect the fundamental economic indicators, whom can they rely on to realign the yields back to a normal state?

The straightforward answers are likely disappointing for the domestic crowd:
1. No, they can't withstand it.
2. The central bank's leverage lies primarily with foreign investors.

Adopting a dollar-centric perspective, one can observe the competition between ten-year U.S

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Treasuries and their Chinese counterparts when priced in dollarsForeign investors tend to concurrently buy ten-year Chinese government bonds while selling off RMB forwards, effectively breaking down their earnings into three parts:
1. Capital gains from ten-year Chinese bonds;
2. Interest income from these bonds;
3. Gains from swap points.

According to the Interest Rate Parity theory, the one-year deposit certificate interest rate added to the swap point earnings should align closely with the Federal Funds RateConsequently, the aggregate of the second and third components gives yields comparable to those of ten-year U.STreasuriesCurrently, if the yields are at 1.70% and 3.09% respectively, this totals 4.79%, which is higher than the four-year yield of 4.51% on U.STreasuriesHowever, the capital gains potential of ten-year Chinese bonds outstrip that of their American counterparts.

The volatility of ten-year U.STreasuries renders them a less favorable investment optionIn contrast, the dollar-denominated Chinese bonds can offer a compelling proposition featuring both higher coupon payments and a positive capital gains trajectory.

For foreign investors, their perspective dissects dollar-denominated ten-year bonds into two distinct accounts: one focusing on the coupon payments and assessing foreign exchange swap points, and another concentrated on capital gains while evaluating the ten-year bond yieldNevertheless, these two accounts operate on differing durations; the coupon payments account has a shorter duration akin to that of money market funds, while the capital gains account possesses a longer duration of approximately eight years.

This disparity creates a unique asymmetric structureWhen one-year deposit rates decline, the coupon payment rates may rise while capital gain yields fall due to their longer duration, subsequently inflating the net value of that account swiftlyConversely, should one-year deposit rates ascend, the opposite effect ensues, and the net value may rapidly diminish

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Such asymmetric structure allows the central bank to effectively guide foreign capital's buying and selling activities in ten-year bonds.

From the perspective of foreign investors, it's evident why ten-year Chinese bond yields recently dipped to as low as 1.60%: the central bank is actively steering down the one-year deposit rates, resulting in the ten-year bonds priced in dollars yielding substantial returns, leading to a buying frenzyHowever, domestic investors maintain their evaluations through a RMB-based lens, often failing to compare dollar-denominated ten-year bonds with U.STreasuries, opting instead to justify the situation with claims of a deteriorating economy.

Despite the obfuscation present in domestic evaluations, another stakeholder remains acutely aware of this logic: the U.STreasuryShould ten-year dollar-denominated bonds become excessively attractive, it stands to reason that fewer clients would opt to purchase American Treasuries.

In a recent speech, a prominent figure raised some substantial concerns:
1. He is vigilant regarding currency manipulation.
2. A strong dollar policy does not provide justification for other countries to adopt a weak currency policy.

While it is apparent to whom he is directing his remarks, domestic investors blinded by the RMB lens often misinterpret such messages as pertaining to others.

The central bank’s recurrent assertion that current ten-year government bond yields do not reflect the economic fundamentals illustrates a disconnect with domestic investors who remain skeptical about the feasibility of achieving a 5% GDP growth rate in 2024. This leads to an essential inquiry: How can interest rates serve as a reliable gauge for the domestic economic fundamentals? The answer may lie in the dollar-denominated ten-year bond rates.

If China's fundamental economic landscape were compromised, the yield gaps would significantly diverge, revealing speculative sovereign credit risk

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This dynamic mirrors behavior observed in credit bonds; as a company, say Vanke, faces considerable credit risks, the yield on its bonds would surgeConversely, when credit risks abate, bond yields would plummetRecently, the narrowing yield differentiation suggests China's economic fundamentals remain stable; otherwise, we would observe a swift divergence akin to that of Russian bondsThus, it’s understandable that the central bank feels aggrieved as they point out that the RMB-priced ten-year bond yield fails to reflect the underlying economic fundamentals.

In conclusion, the critical question remains, should we analyze the situation through a dollar-centric lens or maintain our RMB focus? It becomes apparent that both the central bank and the U.STreasury, alongside foreign investors, primarily adopt a dollar perspective, leaving domestic investors at a disadvantage by viewing the scenario through the RMB lens.

From a dollar-based viewpoint, the implications are resolute: as long as the central bank tightens liquidity and increases one-year deposit rates, foreign investors will consistently offload long-term bonds into the marketYet, domestic investors, lacking a comprehensive understanding of these dynamics, may believe they see an opportunity and continue to absorb the foreign capital being offloaded until a crisis of confidence emerges within their clientele, reminiscent of market events from Q4 2022.

Many in the industry are attempting to justify the rationale for “lowering the RRR and interest rates.” However, I would caution such assumptionsThey either presume that China has supplanted the U.S. as the dominant economy or that China operates within a closed economic framework.

Plainly, we are still a non-U.S. nation with sufficient openness in our economyThus, my recommendation is to engage not with the domestic investors or false foreign entities, but rather seek discussions with unrelated foreign investors to grasp diverse insights

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