Summary: Since the fourth quarter of 2023, China's long-term interest rates have undergone a slump without apparent adjustments to monetary policy, a rare phenomenon in over a decade. Various studies attribute this decline to mismatches in supply and demand for long-term bonds, excess liquidity, and increased duration of financial institutions' liabilities.
This article offers a new explanation for the slump in long-term interest rates from the perspectives of long-term inflation expectations and short-term interest rate cut expectations. It argues that the primary factor driving the decline is the decrease in long-term inflation expectations, leading to a reduction in the central tendency of long-term interest rates. As of 2024, the resilience of the U.S. economy and inflation have exceeded expectations, dispelling market participants' expectations of short-term interest rate cuts. Consequently, given the constraints of accumulating high-cost liabilities and widespread mispricing of credit assets, domestic financial institutions seem compelled to increase yields by assuming higher duration mismatch risks (holding long and ultra-long-term government bonds) to meet the yield requirements of accumulating high-cost liabilities.
If the above explanation holds, the evolution path of long-term interest rates depends on two key factors: 1) monetary policy responses to inflation, and 2) the resilience of the U.S. economy and inflation, leading to four possible scenarios. One scenario is: if the resilience of the U.S. economy and inflation weakens but policy efforts are lower than market expectations and the market cannot fully grasp the reaction function of monetary policy, long-term inflation expectations will remain at current low levels, and long-term interest rates will further decrease following the decline in benchmark rates.
