Asset Scarcity Perspective on Long-Term Treasury Bond Rates

The scarcity of assets due to an overabundance of currency chasing too few bond-type assets has made bond yields easier to fall than to rise.

Since 2024, the bond market has significantly bulled, with the 10-year government bond yield and the 30-year government bond yield both falling from around 2.55% and 2.85% at the beginning of the year to around 2.10% and 2.35% currently, respectively, and credit spreads have also been significantly compressed. The formation of the bond bull market is multifaceted, reflecting both the structural transformation of economic development mechanisms and being influenced by cyclical factors of internal and external growth. However, the decline in interest rates is also a monetary phenomenon. If the formation of inflation is due to "too much money chasing too few goods," then the formation of the decline in interest rates is due to "too much money chasing too few bond-type assets," which is also the perspective of asset scarcity in interest rate analysis.

Coincidentally, in the first two decades of the twenty-first century, overseas bond yields also faced a situation where they were easier to fall than to rise, and academia has offered various explanations for this. The "safe asset scarcity" hypothesis analyzes the formation of low interest rates from the perspective of asset supply and demand. For example, former Federal Reserve Chairman Bernanke proposed the "global saving glut" theory. He believed that the formation of low interest rates stemmed from the imbalance of current accounts: emerging Asian countries, in order to build international reserves, tended to reduce imports and increase exports, accumulating trade surpluses, which led to a long-term low interest rate in the allocation of safe assets such as U.S. Treasury bonds. Researchers at the Bank for International Settlements (BIS), such as Claudio Borio, argued that the allocation power of safe assets did not come from the trade surpluses of emerging markets but from the monetary creation of European banks. European banks obtained dollar funds in the U.S. wholesale market and issued dollar loans, forming the U.S. shadow banking system. Funds flowed out of and back into the United States, and although the current account data of Europe and the United States did not show an imbalance, the scale of banks expanded significantly, and the total amount of cross-border bilateral capital flows was enormous. Therefore, they believed that the source of asset scarcity was not an excess of savings but a global banking glut.

Drawing on this theory, we can explain the formation of the two recent asset scarcities in China. Between 2015 and 2016, interbank business developed rapidly, and the typical interbank expansion model at the time was for banks to issue interbank certificates of deposit to obtain funds, and then invest in bond external investments or interbank wealth management to earn profits. Interbank assets did not pay reserve deposits, so theoretically, banks' interbank assets and liabilities could expand significantly in tandem, creating a large amount of money. With stable funding rates, this expansion was profitable, creating a large-scale demand for bond asset allocation, and even leading to a phenomenon where bond yields and wealth management liability costs were inverted. This was the background for the asset scarcity formed between 2015 and 2016. After the end of 2016, regulatory authorities issued a series of "Wealth Management New Regulations" documents and increased the volatility of funding rates, effectively regulating and curbing the disorderly expansion of interbank activities.

The asset scarcity between 2015 and 2016 was mainly due to money creation between banks, and between banks and non-bank financial institutions. The asset scarcity phenomenon since 2021 can be analyzed from both monetary and asset perspectives. From a monetary perspective, bank loans have grown rapidly in recent years, with a high M2 growth rate, but loan growth has mainly been driven by supply factors. On the one hand, banks issued loans at lower interest rates, creating money, and on the other hand, a large amount of loans did not have financing demand support, and the created money eventually flowed into term deposits and high-interest wealth management products, also forming a monetary phenomenon of high M2 and low M1 coexistence. From an asset perspective, with the transformation of economic growth models, traditional high-interest assets represented by real estate and urban investment have gradually decreased, especially after the introduction of a new round of local government hidden debt resolution policies in 2023, the supply of urban investment assets has further shrunk. The money creation driven by low-interest loans and the asset shortage brought about by the transformation of development models have jointly formed the recent asset scarcity phenomenon.

The formation of the asset scarcity pattern has had a profound impact on the bond market and has changed the traditional bond market analysis framework. The structure of bond market participants has changed, with rural commercial banks becoming important participants in the bond market. After the deposit rate cut in December 2023, rural commercial banks' deposits were relatively slow to adjust, making them relatively attractive, coupled with the inflow of deposits into rural commercial banks during the Spring Festival. This has led to a relatively abundant liability side for rural commercial banks, ultimately leading to their active bond allocation behavior in the first quarter of 2024, triggering a decline in bond market yields. Under the backdrop of asset scarcity, large banks, insurance companies, and other traditional allocation institutions have also increased their allocation ratios for bond-type assets.

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The subsequent evolution of the asset scarcity determines the changes in the bond market. The 2023 Central Financial Work Conference pointed out to "activate financial resources occupied by low efficiency and improve the efficiency of fund use." Subsequently, the central bank implemented and emphasized, "activating existing loans, improving the efficiency of existing loan use, and optimizing the direction of new loan investments are equally important for supporting economic growth." The policy has shifted from the previous emphasis on quantity and bank expansion to the current emphasis on quality over quantity and bank contraction. The shift in policy thinking has led to a continuous decline in M2 growth since the beginning of 2024.

Theoretically speaking, the previous expansion of banks and the increase in money creation brought an increase in allocation power, so will the current contraction of banks and the reduction of money lead to a decrease in allocation power, thereby alleviating the phenomenon of asset scarcity? The real logic is not so straightforward. First, during the process of bank contraction, financial disintermediation and the expansion of non-bank financial institutions have occurred simultaneously. A typical example is the second quarter of 2024, after the regulation banned manual interest supplementation, on the one hand, low-interest low-efficiency loans and high-interest arbitrage deposits in banks decreased simultaneously, and on the other hand, funds flowed from banks to non-bank financial institutions, making non-bank funds relatively abundant, and their allocation behavior towards bond assets became more active, forming a non-bank driven bond market trend. Second, during the process of bank contraction and the reduction of money, the demand for reserve funds by banks also decreased synchronously, leading to an overall abundance of liquidity in the interbank market, making it easier for fund rates to fall than to rise.

Looking ahead, the alleviation of the asset scarcity phenomenon requires a reduction in money supply and an increase in asset supply. In terms of money, the financial process of activating existing stock and squeezing out水分 is still ongoing, and the money supply has already slowed down, but it has also brought about a passive easing of liquidity in the interbank market. After the financial squeezing out of水分 process is completed, the liquidity in the interbank market will also form a new equilibrium state with the money supply. In terms of assets, the current concentrated issuance period of government bonds can increase asset supply in stages, alleviating the phenomenon of asset scarcity, thereby bringing about a pulse-like rebound in interest rates, but the duration is not long. The continuous increase in asset supply requires an increase in fiscal strength or the stabilization of real estate financing. Therefore, in the medium term, the pattern of asset scarcity is still difficult to change.