Nomura: Liquidity Tightening Plus Supply Surge Reaffirms Bearish Stance on 3-Year Interest Rate Swaps

Overview

Nomura released a China interest rate strategy report. The core view is to maintain a 'Pay' position on the 3-year No-Delivery Interest Rate Swap (NDIRS), aiming to push rates up to 1.60% by the end of July. The report argues that the primary driver in China's current interest rate market has shifted from fundamentals to liquidity and supply-demand dynamics. On one hand, the central bank has been continuously withdrawing liquidity through medium-to-long-term monetary policy tools since March, reversing the previously loose funding environment. On the other hand, government bond issuance in the first five months was sluggish, implying a concentrated supply peak is coming in the third quarter. Additionally, domestic funds, having purchased long-dated bonds in bulk earlier, have begun taking profits and selling, further exacerbating upward pressure on rates.

Core views

Liquidity normalization has occurred substantively. The report notes that despite a temporary decline in rates in late May due to MLF rate cuts and short-term injections, rates rebounded sharply by 4-5 basis points entering June. The key signal is the 7-day Repo Fixing Rate returning above 1.4%, alongside significant rebounds in DR007 and 1-year NCD yields since June 5. This validates the lagged effect of the central bank's cumulative net withdrawal of approximately RMB 161 billion of medium-to-long-term liquidity via tools such as ORR since March. Year-to-date, the central bank's net injection via medium-to-long-term tools stands at only RMB 140 billion, far below the average of RMB 1.1 trillion during the same period from 2020 to 2025. Looking ahead at the remainder of June, considering the massive maturity of NCDs (over RMB 900 billion in the next two weeks), tax payment seasons, and potential acceleration in local bond issuance, we expect the 7-day repo rate to continue climbing toward 1.50% or even higher. Bond supply pressure will be concentrated in the third quarter. As of the end of May, the completion rate of the annual net financing quota for treasury and local government bonds was only 35%, lower than the 39% achieved in the same period of 2025, with local bond issuance notably behind schedule. This 'low early, high later' rhythm implies immense supply pressure subsequently. The report forecasts that government bond net supply in June will rise to approximately RMB 1 trillion, climbing further to RMB 1.3 trillion in the third quarter before falling to an average monthly RMB 900 billion in the fourth quarter. The surge in supply not only directly drains liquidity but may also accompany accelerated fiscal spending, improving growth expectations and thus providing dual support for rising rates. Demand side shows signs of profit-taking, though long-end anchored by insurance allocation. Domestic funds purchased massive amounts of ultra-long-dated treasury bonds and政策性 financial bonds in April and May, but have begun reducing positions since June. Selling pressure has spread from the middle of the curve to the long-end. However, regarding the 30-year treasury bond, the report suggests it may perform relatively steadily: firstly, the spread between the 10-year and 30-year bonds is approximately 49 basis points, offering a thick safety cushion; secondly, insurance institutions have shown a willingness to buy against the trend, consistent with their historical pattern of 'buying on dips, selling on rallies.' If the 30-year treasury yield rises to 2.25%, we expect more allocator participation, thereby limiting upside space. Strategy prefers 3-year over 5-year. The report explicitly states that the treasury yield curve is unlikely to steepen significantly until there is substantive improvement in economic data (such as credit and retail sales) or extreme liquidity tightening (e.g., DR001 rises to 1.50% and DR007 to 1.60%). Therefore, compared to 5-year instruments, the 3-year NDIRS offers a better risk-reward ratio. Currently, NDIRS rates are approximately 3 basis points lower than onshore IRS, slightly wider than the 12-month average, which favors the Payer side.

Analysis framework

The report employs a three-dimensional analysis framework of 'Liquidity-Supply/Demand-Quantitative Signals' to assess short-end interest rate trends. First, by dissecting central bank balance sheet operations (OMO, MLF, ORR, Treasury bond purchases/sales), it distinguishes between the pacing of short-term and medium-to-long-term liquidity injection to judge the true tightness of funding conditions, rather than relying solely on daily operation volumes. Second, combining government bond issuance progress with historical seasonal patterns, it proactively forecasts future supply shocks and their secondary impact on funding conditions. Finally, it introduces the proprietary China Interest Rate Trading Model (CHaRT). The model synthesizes liquidity indicators, market technicals, and macroeconomic data; when the index exceeds 0.5, it signals rising rates. In this edition, the model reading rose to 0.60, confirming that liquidity and technical factors have become the dominant drivers, providing quantitative validation for maintaining a short position.

Methodology notes

• Macroeconomic frameworkMonetary-Credit Four Quadrants

  Transmission relationship between central bank net medium-to-long-term liquidity injection and short-end rates

  The report analyzes changes in net injections via medium-to-long-term tools like ORR and MLF to gauge the abundance of base money in the banking system. When the central bank continues to withdraw medium-to-long-term liquidity on a net basis, even if short-term OMO remains stable, costs on the liability side of banks will gradually rise, eventually transmitting to DR007 and NCD rates. This is the core logic for understanding the convergence of funding conditions in this round.

• Fixed Income and Credit AnalysisYield curve analysis

  Trading implications of term spreads and curve shapes

  The report focuses on the spread between 10-year and 30-year treasury bonds (approx. 49bp) and the swap spread between 3-year and 5-year tenors to evaluate value-for-money at different curve locations. A wider short-long spread provides a buffer for 30-year bonds, while the advantage of the 3-year relative to the 5-year stems from expectations of curve flattening. This analysis based on relative spread value forms the foundation for interest rate strategy formulation.

• Industry/Industrial Analysis FrameworkSupply and Demand Framework

  Government bond issuance progress and seasonal supply shocks

  By comparing the completion rate of government bond quotas for the current year versus previous years (e.g., only 35% completed by end-May), the report identifies misalignment in the issuance rhythm. This 'slow early, fast later' pattern indicates that a concentrated supply surge will occur in specific future periods (such as Q3), subsequently becoming a key variable driving up rates, reflecting the typical supply-demand pricing logic of the bond market.

Key data

• 3-Year NDIRS Target Rate1.60%Target level set by the report for late July, implying a bearish stance on short-end rates
• Year-to-Date Net Central Bank Medium-to-Long-Term Liquidity InjectionRMB 140 billionFar below the average of approx. RMB 1.1 trillion during the same period from 2020-2025, indicating substantial liquidity contraction
• Government Bond Issuance Progress as of End-May35%Completion rate for both treasury and local bonds stands at 35%, lower than the 39% in the same period of 2025, foreshadowing Q3 supply pressure
• Forecast for Average Monthly Net Government Bond Supply in Q3RMB 1.3 trillionA further increase from RMB 1 trillion in June, representing the peak supply of the year
• Latest Reading of CHaRT Model0.60Above the 0.5 threshold, signaling rising rates (Pay); the dominant theme is liquidity and market technicals
• Spread Between 10-Year and 30-Year Treasury BondsApprox. 49bpA wide spread provides a buffer against price declines for 30-year treasuries

Impact & implications

For bond market participants, the report's assessment implies that the downside space for short-end rates is effectively closed, and volatility in funding conditions will intensify in the coming weeks. Costs for leverage strategies in the interbank market may rise, requiring caution regarding valuation corrections caused by liquidity frictions. For interest rate swap traders, the current NDIRS is trading at a discount of approximately 3 basis points relative to onshore IRS, and the model signal has turned bearish, offering a tactical window for shorting. Simultaneously, the aggressive buying behavior by allocators such as insurance institutions in the 30-year treasury bond suggests a potential interim top in long-end rates, discouraging blind shorting of ultra-long-end assets. Overall, the market pricing logic is shifting from 'weak reality + loose monetary policy' to 'supply shock + return of liquidity to normalcy', and trading focus should shift more towards high-frequency funding indicators and government bond issuance announcements.

Risks

• If economic data (especially credit demand and retail sales) improves beyond expectations, it could trigger a significant steepening of the yield curve, resulting in losses for the 3-year short position
• If the pace or magnitude of liquidity tightening far exceeds expectations (e.g., DR001 rises to 1.50% and DR007 to 1.60%), it may trigger panic selling in the market, disrupting the original trading rhythm
• The central bank might increase short-term OMO injections in late June to smooth end-of-quarter volatility, leading to less tight funding conditions than anticipated

What to watch

• Announcement of the 6-month ORR operation published on the evening of June 12 (RMB 600 billion due on the same day)
• Release of May economic activity data next Tuesday
• Whether local government bond issuance plans accelerate as scheduled in late June
• Whether the yields of 10-year and 30-year treasury bonds reach critical levels of 1.75% and 2.25% respectively, observing whether there is buying support
• Daily trends of DR007 and 1-year NCD rates to verify the continuity of the liquidity tightening trend