Migrated – Original Post Date: Mar 12, 2021

by Dr. Hou Zhenhai
Straits Financial (China) Chief Strategist



  • Surging US bond yields, in addition to economic recovery and inflation expectations, due to expectations on the further imbalance of US long-term bond supply and demand, esp. after a new round of $1.9trillion fiscal stimulus. Q4 2021, the supply of US long bonds rose fast, far exceeding the purchase from Fed’s QE program.
  • The Feds will either buy more long T-bonds or for the Treasury to decrease T-bonds offering. Depending on how Treasury Department reduce T-bond issuance. Our view that the market may have overestimated the supply pressure of T-bonds.
  • Early March, US Treasury may issue a new round of 10y and 30y T-bonds, which is a stress test of the market’s appetite for long bonds. If the issuing yield does not rise much and the bidding multiples are maintained below 2x, it should help to stabilize the market confidence.
  • The market may be too optimistic towards the vaccine leading to an earlier recovery of Covid-19 and reopening of economies. If the US and UK are to lift the restrictions early, they may risk another surge of new infections, just like what France and Italy are experiencing now.
  • Chinese government set a GDP growth target of 6% this year. The lower targets meant for accommodative fiscal and credit policies aimed at countering the pandemic will gradually end by this year. We maintain our view on commodity outperformance, esp. those driven by foreign demand, such as nonferrous metals and petrochemical products.
  • Our last review suggested that investors should be cautious about A-shares around 3700 points or after the Spring Festival. At present, the risk has declined in the NAV of domestic equity funds which may lead to a reverse of fund subscription fever in domestic investors. The A-shares index will probably maintain weak consolidation trend under 3500 points, and it is still difficult to see the bull market returning in the near future.


I. Market may have overestimated the future supply pressure of the US treasury bonds

Since February, the yields of US medium and long-term treasury bonds have shown a significant upward trend, of which the yield of 10-year has exceeded 1.5% for the first time since the Covid-19 pandemic, and the significant upward trend of interest rate has caused significant pressure on the global equity market. The market’s explanation for the rise in treasury bond yields is mainly the rise in the expectation of future US economic recovery and inflation. However, we believe that in addition to these expectations, another important reason for the recent surge in US Treasury yields is the significant increase in the issuance of US medium and long-term treasury bonds. Moreover, as the US is about to pass a new round of fiscal stimulus of $1.9 trillion, the market’s concern about the increase in the supply of US Treasury bonds in the second quarter is also rising significantly.

Since the outbreak of Covid-19, outstanding total US Treasury bonds has increased significantly. But before the fourth quarter of last year, US fiscal deficits were mostly financed through the issuance of short-term treasury bills under 5 year. However, since November last year, the U.S. Treasury has gradually increased the issuance of long-term treasury bonds. The monthly net financing amount of long-term treasury bonds with various maturities from 5 to 30 years has exceeded $140 billion since November at $166.4 billion, a record high ever recorded (Figure 1).

Source: Bloomberg, CEIC, Wind

On the other hand, the Fed has become a significant net buyer of treasury bonds in the market through its new QE program. Especially last March and April, it bought large-scale net U.S. Treasury bonds as much as $1.3 trillion, which was much larger than the net supply of US medium and long-term Treasury during that period. As a result, the long end bond yield declined. But now, the Fed’s QE has stabilized at roughly $120billion a month, among which net purchases of US mid and long-term Treasury bonds are at a level of roughly $70-80billion a month (Figure 2). This means that, from the beginning of Q3 through Q4 last year, the supply pressure on US medium and long-term treasury bonds continues to amount.

If current situation remains for the net issuance of US mid & long-term Treasury bonds per month surpassing the Fed’s QE purchase by over $100billion a month, the supply and demand imbalance will inevitably lead to a further steepening of the US Treasury yield curve. There are only two ways to alleviate the imbalance: one is for the Fed to buy more long bonds; the other is for the US Treasury Department to reduce the issuance of mid & long term bonds.

Source: Bloomberg, CEIC, Wind

On the first method, the Fed to buy more long duration bonds. The most direct and effective way to achieve this is for the Fed to increase QE. However, as the current US economic data are improving and the market’s expectations for the economic recovery and inflation are also rising, the Fed does NOT have a solid reason to enlarge its QE program. Another way to achieve this is for the Fed to adopt “Operation Twist” or “Yield Curve Control”. However, if we look at the Fed’s balance sheet, as of March 3, the total amount of Treasury bonds held by the Fed was $4.86 trillion, of which only $326 billion were short-term treasury bills and the remaining $4.53 trillion were all mid & long-term treasury bonds. This means that the Fed has very limited space for Operation Twist without increasing its QE. Of course, Fed still holds $2.13 trillion MBS. Therefore, in theory, it can reduce the amount of MBS purchase or even sell its current holdings, and purchase more mid & long-term treasury bonds to suppress the long end yields.

The second method to reduce the supply pressure of treasury bonds is to liquidate Treasury Department’s Federal Reserve Account, i.e. the so-called Treasury Gross Account (TGA) to pay the future fiscal expenditure and repay part of maturing treasury debts. We believe that in the next three months, this approach will play a more important role on the rebalancing. This is because, since the pandemic outbreak in the US last year, the net treasury debt financing reaches $4.5 trillion, but the actual fiscal deficits are roughly $3.5 trillion. Therefore, US Treasury Department still has nearly $1.4 trillion on their Federal Reserve Account (Figure 3). The Treasury Department has now announced to reduce that number by more than $800 billion by the end of Q2, of which 400 billion is planned to be used to repay the maturing treasury debts, and the rest for the new fiscal spending. Therefore, even if the US introduce a new round of fiscal stimulus plan in near future, the supply pressure of US Treasury bonds next quarter is likely to be lower than the concerns by the market.

Source: Bloomberg, CEIC, Wind

On March 9 and 10, US Treasury Department will auction a new round of 10-year and 30-year treasury bonds, respectively. The market still remembers that on late February, the 7-year US treasury debts auction saw a bidding multiple hitting a 12-year new low of 1.86x. This week’s auction of 10-year and 30-year treasury bonds will be an important stress test of the market’s appetite of long-term treasury bonds. If market passes this stress test successfully, i.e. the highest auction yield does not rise significantly and the bidding multiple remain aloft over 2.0x, we expect the market pressure on stocks and commodities should also reduce. On the contrary, the long-end treasury bond yields may rise again, causing further pressure on the market.

In the medium term, we do not think the long end yield will have much room to rise. Taking the 10-year bond as example, we believe that the Fed and Treasury Department still have the ability and tools to keep it below 2%. However, we expect the yield may top in Q2, after the market fully digests the pressure of treasury bonds brought by the new round of fiscal stimulus and the optimistic expectation of economic recovery.

II. Market may be overoptimistic about vaccine to end pandemic early

Another recent factor driving up bond yields is the improvement of Covid-19 infections in the US and UK. In addition, vaccination is also accelerating in the US and developed EU countries. So the market is optimistic that we may finally see the light at the end of the pandemic tunnel.

However, we think the reality may not be so optimistic. Admittedly, the number of new infections per day in the US and UK have dropped significantly recently, but this decline is more likely due to the “stay home policy and restrictions” previously adopted in these 2 countries, rather than the effect of vaccination. If we compare the current vaccination rates of various countries, the two leading countries are Israel and the United Arab Emirates, with their latest total vaccination rates of 97.5% and 62.4% respectively (Figure 4). With such a high vaccination rate, the decline rate of new daily infections in these two countries is still significantly lower than that in the US and UK. The total population of both countries is about 9 million, and the number of new infections per day continues to maintain at about 3000, which indicates that they are still not reaching herd immunity so far.

Figure 4. Daily new infections and vaccination in Israel and UA

Source: Bloomberg, CEIC, Wind

Source: Bloomberg, CEIC, Wind

This means that if the US and UK totally lift the restrictions now, the number of new infections may surge again in the future, as the vaccine still cannot replace the restrictions effectively before reaching herd immunity. Comparing France, Italy and the UK, which are close in terms of population, geographical location, economic scale and healthcare standard. The pandemic situation in these three countries as showed in daily new infections are mostly correlated to their restriction periods (Figure 5). France adopted its restrictions on October 20 last year, and the number of new infections dropped significantly after November. However, restrictions ended in France before Christmas and was replaced by partial outdoor restrictions. As a result, the number of new infections in France after January actually rose again. The same situation happened in Italy too. In the UK, however, it was only after new outbreak worsened significantly and on January 4, 2021 that restrictions was adopted till now. As a result, the decline in infections in the UK is most significant after January.

Source: Bloomberg, CEIC, Wind

If restrictions is still the way to curb infection rates now, then the risk of fully opening up again is still great, and the sustainability of economic and employment recovery is questionable. The data from Israel and the UAE show that it will take quite a long time for countries to reach herd immunity even with very high vaccination rate. Therefore, we believe that the market’s current expectation on major developed countries in curbing the infection by vaccine for a recovery on their economy, in our view is likely to be too optimistic.


Based on the above analyses, the market may overestimate the short-term supply pressure of US Treasury bonds, and at the same time expect an early pandemic control and economic recovery. Therefore, we are not worried about the further sharp rise of US Treasury bond yields. For the Fed and US Treasury Department, 10-year Treasury bond yield between 1.5% and 2% is acceptable, and there is no need to make intervention too early (such as increasing QE or yield curve control). However, as the market, especially the equity market, hangs over a high valuation now, it will take some time for the market to digest a 10-year yield slightly higher than 1.5%. Therefore, we believe that overseas stock markets are still under pressure, and the US stock index is more likely to fluctuate at the current levels. At the same time, the equity market structure will continue to switch, and the market style will continue to favor some sectors that benefit from economic recovery and lower PE valuation, such as finance, energy, raw materials and consumer discretionary. However, there are still some short-term adjustment pressures on technology, consumer staple and healthcare, which outperformed last year and were valued more expensively now.

We think that the long-term opportunity in the US equity market may appear in the middle and late March. With the launch of a new round of fiscal stimulus, most US residents will get a new check of $1400 per person around the end of March. A considerable part of this capital, we believe and also showed in certain survey, will still be invested in the stock market. Therefore, we may see another equity market rally then.

III. Chinese domestic market

Although the rising bond yields and equity selloff in overseas markets have a certain impact on the domestic market, we believe that these effects still mainly are psychological. The real impact on the domestic market will still be mainly on domestic economies and policies. With the gradual stability of overseas markets, the focus of domestic market will gradually return to the fundamentals and credit/liquidity situation.

First of all, during the annual National People’s Congress and the Chinese Political Consultative Conference (NPC & CPPCC) held last week, the new government work report set the GDP growth target at 6% this year, which means that the pressure on the government to maintain growth this year will be very low, given last year’s low base effect. GDP grew only 2.3% in 2020. Even with a low end potential growth of 5.5% per year, the growth rate of domestic GDP is expected to growth around 8%, on the basis of a successful domestic control of the pandemic. What’s more, overseas demand has begun to recover, which will have a huge pulling effect on China’s exports. In this case, if the growth target is only 6%, it means that the Chinese central government has a huge space to adjust its domestic fiscal, monetary and credit policies.

In fact, our understanding is that domestic macro policies, especially fiscal and credit policies, are always “a hedging policy”, that is to say, the worse the global economy might be, the more proactive the domestic policies will be. At present, if overseas exports and domestic manufacturing investment continue to accelerate, it means that the domestic accommodative policies may end earlier. This will not only be reflected in the issuance suspension of “pandemic alleviation special purpose treasury bonds” this year, but also in the exit of proactive fiscal policies. We believe this will also be reflected in the gradual tightening of domestic credit, including the conditions on corporate bond offering and incremental resident loans (especially residential mortgages).

On the whole, from the economic point of view, we think that the general situation is that “the external demand continue to improve with the domestic demand falling steadily”. In terms of asset allocation, we maintain our domestic views proposed before that “commodities will outperform, bond interest rates may peak and begin to fall late this year, but equity stocks continue to be relatively weak”. In terms of commodities, we are positive especially on those highly benefited from the recovery of overseas demand, such as non-ferrous and petrochemical products. Relatively speaking, precious metals will be the weakest in the short term, because the rising yields and the expectation of economic recovery are both unfavorable to precious metals.

In our last review, our view on A-shares “the best performance in the first half is before Spring Festival, and the index target is around 3700.”. At the same time, we suggest that “investors should be cautious about A shares after Spring Festival in Q2.” At present, the market basically confirms our previous judgment. The market rose rapidly before the Spring Festival to around 3700 and then fell rapidly, especially the previous strong “institutional hoarding” equity names.

For the future trend of A-shares market, we think the most critical indicator is still the amount of equity fund subscription, because we know that the main driving force of this round of A-shares bull market since 2019 is based on the transfer and allocation of residents’ funds from the previous Trust and Wealth management products to equity funds. At the same time, due to the fund’s high equity positions and centralized shareholding, if the market falls sharply or sector rotates just like what happens now, most large-scale equity funds are difficult to follow the change in the short term, so a NAV decline may happen and even drive a wave of fund redemption. This has not happened, at lease for the time being, but the speed and the scale of fund raising after the Spring Festival have slowed down compared with that before the Spring Festival (Figure 6). Therefore, we believe that the A-shares is likely to continue to fall back under 3500 points (Shanghai Composite Index) and consolidate, it is still difficult to see the bull market returning in the near future.

Source: Bloomberg, CEIC, Wind

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