Summary

As the window for interest rate cuts approaches again, from the perspective of stabilizing growth logic, it is indeed necessary to lower both the reserve requirement and interest rates. However, merely extrapolating from recent small and medium-sized banks' deposit rate cuts to predict a rate cut in April seems to lack rigor. It is believed that regardless of whether the reserve requirement and interest rates are lowered next week, this may not immediately drive interest rates below previous lows. After all, the market needs to navigate the trade friction between China and the USA, the intensity of a package of incremental policy measures, and the selection of monetary policy, all of which are dynamic and full of uncertainties. Therefore, it is essential to grasp certainties: first, the fundamental pressures remain, and there are limited incremental signals beyond monetary policy. In the medium term, the possibility of monetary policy easing is relatively high, and there is significant room for it. Second, the short-term adjustments are insufficiently bearish, with an enhancement in monetary support. Hence, it is recommended to maintain a bullish mindset and buy on adjustment.

Based on the past adjustments of bank deposit rates and the timing of central bank interest rate cuts, the rhythm of deposit rate adjustments by large banks is getting closer to the central bank's interest rate cuts. The current round of deposit rate cuts by small and medium-sized banks resembles a compensation adjustment following the interest rate cut in September last year and cannot solely result in a judgment that predicts the proximity of the central bank's interest rate cuts. The decrease in deposit rates and the central bank's rate cuts influence each other and are constrained by the interest rate discipline mechanism, with large banks' deposit rates responding more promptly to policy rates. Currently, the concentration of deposit rate cuts among small and medium-sized banks is partly due to the pressure on net interest margins and also related to the end of the "New Year Red" campaign and reduced demands for deposit collection.

If both cut measures occur in the second quarter, how will the market react? In summary, the market trend after lowering the reserve requirement and interest rates depends crucially on the intensity of incremental policies beyond monetary policy and whether these can stabilize the fundamentals and effectively boost market expectations. If so, interest rates may rebound in the short term, followed by further assessments of the continuity of incremental policies; if not, interest rates may continue to decline, and the previous market rush is not critical, for instance in February and July 2024.

During this monetary easing cycle, long-term yields usually decline initially after an interest rate cut, with the extent of the decline roughly aligning with the rate cut. Subsequently, the market typically takes profit within two weeks, leading rates to return to levels prior to the cut, with the curve shape flattening first and then steepening. After a reserve requirement cut, the bond market exhibits mixed rate movements, influenced by changes in funding rates and expectations regarding broad monetary policy and stable growth. In the short term after a reserve cut, the curve tends to steepen, but the rules in the medium term are not significantly evident.

What if both cuts do not happen? Currently, market expectations are converging, and investors generally hold the view of being moderately bullish in the medium term while expecting short-term fluctuations. From the perspective of institutional behavior, a wave of interest rate rebounds at the beginning of the year resulted in an unfavorable start for the bond market, and a significant portion of investors missed out during a rapid market movement in early April. Consequently, while bond fund performance has slightly improved, the annual targets have yet to be met, showing a noteworthy difference in institutional investor sentiment compared to the first half of last year.

Looking ahead, for medium to long-term bond funds, maintaining a high duration seems to become an 'inevitable choice.' The direction of monetary policy easing has been underestimated, but the rhythm carries uncertainty. To avoid missing out again, investors’ reluctant decision is to remain with a longer duration waiting continuously; otherwise, during previous declines, there was no resistance, and later, during rises, they won't outperform the benchmark, facing even greater pressure on the liability side.

For short-term Bond Funds and MMFs, the central bank has increased support for primary issuance and tax periods, and liquidity is unlikely to experience a situation similar to February, so it is still recommended to mainly hold bonds and maintain a bullish momentum.

Report body

Whether to cut or not, how will the market respond?

1.1 After the reduction of deposit interest rates, does it signal an imminent rate cut?

Since April, shareholding banks such as Ping An Bank and Shanghai Pudong Development Bank, as well as many city commercial banks and rural banks, have successively lowered deposit interest rates. Does this mean a rate cut is approaching?

Based on past adjustments of bank deposit rates and the timing of central bank interest rate cuts, the timing of large banks adjusting deposit rates is more in line with the impending central bank rate cuts. The recent adjustments by small and medium-sized banks seem more like adjustments following the rate cuts in September last year, and cannot solely be used to determine the proximity of central bank rate cuts.

In August 2022, economic data fell short of expectations, and the central bank unexpectedly cut interest rates, lowering the 1-year LPR and the 5-year LPR by 5 basis points and 15 basis points, respectively. In September, large state-owned banks such as ICBC lowered the published interest rates for deposits of all maturities by 10 basis points.

On June 8, 2023, many state-owned banks lowered deposit interest rates, with interest rates for demand deposits lowered by 5 basis points, 2-year deposit rates lowered by 10 basis points, and 3-year and 5-year deposit rates lowered by 15 basis points each. On June 20, the central bank reduced the 1-year and 5-year LPR by 10 basis points each.

In September 2023, state-owned banks lowered deposit rates, with the one-year benchmark rate down by 10 basis points, the two-year benchmark rate down by 20 basis points, and both the three-year and five-year benchmark rates down by 25 basis points. In December, state-owned banks such as ICBC again lowered deposit rates, with three-month, six-month, and one-year rates down by 10 basis points, the two-year rate down by 20 basis points, and both the three-year and five-year rates down by 25 basis points. In February 2024, the central bank applied an asymmetric interest rate cut, lowering the five-year LPR by 25 basis points.

On July 22, 2024, the central bank lowered the seven-day reverse repo operation rate by 10 basis points. On July 25, state-owned banks lowered deposit rates, with the demand deposit benchmark rate down by 5 basis points, and three-month, six-month, and one-year rates down by 10 basis points, while the two-year, three-year, and five-year benchmark rates were each down by 20 basis points.

On September 24, 2024, central bank governor Pan Gongsheng announced at a State Council Information Office press conference that interest rates would be lowered soon. On the 27th, the central bank reduced the seven-day reverse repo operation rate by 20 basis points. In October, several state-owned banks lowered deposit rates, with the demand deposit benchmark rate down by 5 basis points and the benchmark rates for all other terms down by 25 basis points.

From a logical perspective, the reduction in deposit rates and the central bank's interest rate cuts influence each other. Under the constraints of the interest rate self-discipline mechanism, large banks respond to policy rates more promptly regarding deposit rates.

On one hand, deposit rates are adjusted according to the LPR rates. According to the deposit self-discipline pricing mechanism, member banks need to refer to the "10-year government bond yield + one-year LPR → deposit rate" transmission mechanism.

On the other hand, according to the "market interest rates + central bank guidance → LPR → loan rates" transmission mechanism, when the policy side focuses on reducing the financing costs of the real economy, the corresponding LPR guidance needs to be considered, which is influenced by central bank policy guidance (through MLF) and the consideration of market interest rates by quoting entities. Market interest rates do not simply correspond to government bond yields but relate to rates on deposits and other liabilities.

Currently, deposit rates for small and medium-sized banks are being collectively reduced, partly due to net interest margin pressure and partly related to the end of the "New Year Red" season and a decline in the demand for deposit gathering.

1.2 How will the market move if there is a double cut?

From the perspective of this round of MMF easing cycle, after a rate cut, long-term yields typically first decrease, and the extent of this decrease is generally consistent with the rate cut. Subsequently, the market takes profit within two weeks, and interest rates essentially recover to pre-rate cut levels. Looking further ahead, one needs to observe the strength of incremental policies outside of MMF, the fundamental situation, and changes in market expectations.

Regarding the shape of the curve, after a rate cut, the curve usually flattens then steepens.

It is noteworthy that during the two rate cuts in July and September last year, the market behaved slightly differently. For instance, after the July rate cut, if there was no influence from the central bank and major banks selling bonds, the market would not seem to take profit, as the strength of policies outside of MMF was relatively weak and did not stop the downward trend of the fundamentals or effectively boost market expectations. After the September rate cut, interest rates rebounded directly, partly because the market had anticipated the changes too much beforehand, and also related to the strong strength of incremental policies outside of MMF, which significantly boosted market expectations.

Specifically, on January 17, 2022, the central bank lowered the MLF and OMO rates by 10 basis points, and the yields on 10-year government bonds and 10-year policy bank bonds fell by 0.8BP and 0.2BP respectively compared to the previous trading day; by the next trading day after the rate cut, the yields on 10-year government and policy bank bonds had decreased by 4.5BP and 5.6BP respectively compared to the previous trading day. This round of rate cut trading lasted for six trading days, leading to a decrease of approximately 11.8BP and 17.3BP in the 10-year government bonds and 10-year policy bank bonds respectively. Subsequently, impacted by factors such as the rebound in month-end bill rates, interest rates continued to rise, with the yield on 10-year government bonds rebounding to 2.84% on March 9, 2022, 4.9 BP higher than before the rate cut.

On May 20, 2022, the central bank asymmetrically lowered the LPR, and the yields on 10-year government bonds and 10-year policy bank bonds increased by 1.3BP and 0.8BP respectively compared to the previous trading day; by the next trading day after the rate cut, the yields on 10-year government and policy bank bonds fell by 2.3BP and 2.0BP respectively compared to the previous trading day. This round of rate cut trading lasted for six trading days, leading to a decrease of approximately 9.3BP and 6.7BP in the 10-year government bonds and 10-year policy bank bonds respectively. Subsequently, on June 16, the State Council proposed not to overly expand MMF and not to overdraw future potential; on June 21, the Premier conveyed similar views during an inspection in Hebei; and on June 29, during an inspection in Wuhan, the General Secretary stated, "It's better to temporarily impact a bit of economic development," leading interest rates to reach a temporary peak, with the yield on 10-year government bonds rebounding to 2.84% on July 4, 2022, 6.7 BP higher than before the rate cut.

On August 15, 2022, the central bank lowered the MLF and OMO rates by 10BP, and the yields on 10-year government bonds and 10-year policy bank bonds decreased by 7.7BP and 7.5BP respectively compared to the previous trading day. The rate cut trading lasted four trading days, leading to a decrease of approximately 15.5BP and 12.5BP in the 10-year government and policy bank bonds respectively. By August 18, 2022, the continuously declining yields on government bonds reached a bottom, coupled with a series of incremental policies beginning to be introduced and implemented, the bond market interest rates began to turn upward, with the yield on 10-year government bonds rebounding to 2.76% on October 8, 2022, 2.8BP higher than before the rate cut.

On June 13, 2023, the central bank lowered the OMO rate by 10bp, and the yields on 10-year government bonds and 10-year policy bank bonds fell by 4.8BP and 5.0BP respectively compared to the previous trading day. The interest rate cut trade lasted only 2 trading days, and by June 14, the yields on the 10-year government bonds and 10-year policy bank bonds dropped by approximately 5.3BP and 5.0BP respectively. Expectations for incremental policies outside of currency warmed up, and after the State Council meeting on June 19, the phase of interest rate adjustments ended, with the yield on 10-year government bonds rebounding to 2.69%, 1.7BP higher than before the rate cut. Due to limited strength in subsequent incremental policy implementation, long-term bond yields resumed a downward fluctuation.

On August 15, 2023, the central bank lowered the OMO rate by 10bp and the MLF rate by 15bp, with the yields on 10-year government bonds and 10-year policy bank bonds falling by 4.5BP and 3.9BP respectively compared to the previous trading day. The interest rate cut trade continued for 5 trading days, and by August 21, bond market yields began to rise, with 10-year government bonds and policy bank bonds decreasing by 8.1BP and 7.5BP respectively. Against the backdrop of a comprehensive debt restructuring and additional issuance of government bonds, combined with exchange rate fluctuations and the prevention of capital from turning over for arbitrage, bond market yields saw a phase of recovery from September to October, with the yield on 10-year government bonds rebounding to a high of 2.64% on September 8, 2023, which was 1.4BP higher than before the rate cut.

On February 20, 2024, the central bank asymmetrically lowered the LPR, with yields on 10-year government bonds and 10-year policy bank bonds falling by 0.5BP and 1.0BP respectively compared to the previous trading day. The interest rate cut trade continued for 5 trading days, and by February 27, bond market yields began to rise, with 10-year government bonds and policy bank bonds dropping by 3.4BP and 6.5BP respectively. Subsequently, expectations for the Two Sessions policy weakened, and weak PMI expectations further pushed rates downward.

On July 22, 2024, the central bank lowered the OMO rate by 10bp, and the yields on 10-year government bonds and 10-year policy bank bonds fell by 1.5BP and 2.0BP respectively compared to the previous trading day. The interest rate cut trade lasted for 10 trading days, and by August 3, bond market yields rebounded, with yields on 10-year government bonds and policy bank bonds decreasing by 13.4BP and 13.9BP respectively. Subsequently, guidance from the central bank on major banks selling bonds was largely confirmed, leading to a reversal in bond market sentiment, with yields rising, and the yield on 10-year government bonds rebounding to a high of 2.25% on August 12, 2024, which was 1.1BP lower than before the rate cut.

On September 24, 2024, the central bank announced a reserve requirement ratio cut and interest rate cuts (OMO rate lowered by 20bp) along with a package of incremental policies, leading to an immediate rebound in rates. The yields on 10-year government bonds and 10-year policy bank bonds rose by 3.47BP and 3.5BP respectively compared to the previous trading day. Subsequently, due to stable growth policy expectations and redemption pressures, yields continued to rebound, with the yield on 10-year government bonds reaching a phase high of 2.25% on September 29, 2024, which was 22.53BP higher than before the interest rate cut announcement.

Since 2020, after the reserve requirement ratio cut, bond market yields have shown mixed fluctuations, influenced by changes in funding rates and expectations for broad monetary policy and stable growth. In terms of curve shape, short-term curves have generally steepened after the reserve requirement ratio cut, but patterns in the mid-term have not been obvious.

1.3 What to do if the dual decrease does not happen?

Current market expectations are largely consistent, with investors generally holding the view of "bullish in the medium term, and fluctuations in the short term."

On one hand, the "New Year’s open" has ended, and the fundamentals have begun to show signs of weakness; on the other hand, equal tariffs have already been implemented, and the possibility of future monetary easing is relatively high.

However, from the Financial Times article on April 13, the central bank is still maintaining a wait-and-see attitude in the short term, with the dual decrease "up in the air." Combined with the fluctuations in trade expectations between China and the USA, as well as China and Europe, interest rates are expected to enter a volatile phase in the short term. During this period, due to factors such as large banks buying bonds and expectations of special treasury bond issuance, long-term bonds performed poorly while short-term bonds performed better, leading to a steepening yield curve.

In addition, from the perspective of institutional behavior, a wave of interest rate rebound at the beginning of the year led to an unfavorable start for the bond market. By early April, the "rapid" market was difficult to grasp, and a significant portion of investors missed out. Therefore, although bond fund performance has slightly improved, the annual target has not yet been achieved, and the mindset of institutional investors shows significant differences compared to the first half of last year.

Looking ahead, for medium to long-term bond funds, maintaining a high duration seems to become an 'inevitable choice.' The direction of monetary policy easing has been underestimated, but the rhythm carries uncertainty. To avoid missing out again, investors’ reluctant decision is to remain with a longer duration waiting continuously; otherwise, during previous declines, there was no resistance, and later, during rises, they won't outperform the benchmark, facing even greater pressure on the liability side.

For short-term bond Funds and MMF, the central bank has increased support for the primary issuance and tax periods, and liquidity is unlikely to replicate the situation of February, therefore the risk of adjustment for CD and short-term bonds is limited. Currently, it is still recommended to mainly hold bonds and maintain a bullish momentum.

From a seasonal perspective, the strong performance in the second quarter has ended, combined with the fact that in the last three years there have been regulations/reductions in deposit interest rates, non-bank funding is relatively abundant, with Funds, securities asset management, REITs, wealth management, rural commercial banks, and Insurance contributing the main bullish forces.

The funding is generally balanced and loose, with interest rates declining.

From April 14 to April 18, the yield of the 10Y actively traded national bonds (250004.IB) went down first, then up, and then down again. In terms of valuation, the yield of the 10-year national bonds decreased by 0.75BP to 1.65%, while the yield of the 10-year national development bonds decreased by 1.9BP to 1.68%. The yield spread between 1-year and 10-year national bonds narrowed by 3.97BP to 21.93BP, and the yield spread between 1-year and 10-year national development bonds narrowed by 3.42BP to 11.07BP.

This week’s daily review:

Last week, the Central Bank's open market shifted to net issuance, with overall funding being slightly loose. Rumors of a reserve requirement ratio cut, regulations on interbank deposits, and market speculations regarding the LPR were bullish for the bond market; however, financial data exceeded expectations, the Financial Times reiterated 'moderate easing,' economic data also exceeded expectations, the Ministry of Finance announced the 2025 national bond issuance plan, signs of progress in the China-US negotiations, and rumors of incremental policies in the real estate sector were bearish for the bond market. Throughout the week, bond market yields declined, with national bonds and policy financial bonds' yield curves flattening, while credit bonds' yield curves steepened. The long-term yields of national bonds and central government bonds decreased, while other yields mainly went up, with the 10-year national bond yield down 0.75bp to 1.65%.

On Monday, the Central Bank's reverse repos net withdrew 50.5 billion yuan, with funding being slightly loose. Over the weekend, financial data exceeded expectations, the Financial Times reiterated 'moderate easing,' and the bond market opened high before declining. In the afternoon, rumors of a reserve requirement ratio cut emerged, along with afternoon rumors regulating interbank deposits, causing interest rates to decline slightly before fluctuating. Throughout the day, the 10-year national bond yield rose by 0.16bp to 1.66%.

On Tuesday, the Central Bank's reverse repos net withdrew 2.9 billion yuan, and 100 billion yuan of MLF matured, with overall funding being balanced. The stock market initially fell before rising, the bond market's interest rates declined and then rebounded, with wide fluctuations in rates in the afternoon. Throughout the day, the 10-year national bond yield decreased by 0.01bp to 1.66%.

On Wednesday, the central bank's reverse repurchase operations netted 14.4 billion yuan, with overall funds balanced. The economic data for the first quarter released in the morning exceeded expectations, but the market reaction was muted. The equity market fell, and bond market rates declined. Near noon, the Ministry of Finance announced the 2025 national debt issuance plan, leading to a pulse upward in rates before falling back. In the afternoon, rates fluctuated. Bloomberg reported that 'if Trump shows respect, China will open negotiations and designate a person in charge,' causing rates to turn upward, resulting in a decline of 1.53 basis points in the 10-year Treasury yield to 1.64% for the day.

On Thursday, the central bank's reverse repurchase operations netted 179.6 billion yuan, with overall funds balanced. In early trading, rumors circulated about incremental policies for real estate, leading to a low opening and subsequent rise in the stock market, while bond market rates increased. In the afternoon, there was a slight tightening of funds, with the A-shares maintaining strength and rates continuing to rise. The 10-year Treasury yield increased by 0.92 basis points to 1.65% for the day.

On Friday, the central bank's reverse repurchase operations netted 222 billion yuan, with overall funds balanced. In early trading, the market was speculating whether the LPR would be lowered, causing rates to fluctuate widely. At noon, Trump indicated a willingness to lower tariffs, prompting a rise in bond market rates in the afternoon. The 10-year Treasury yield decreased by 0.29 basis points to 1.65% for the day.

Next week (April 21 - April 25) bond market focus:

China's April one-year and five-year loan market quotation rates (LPR) (April 21)

The State Council Information Office will hold a press conference regarding the 'Accelerating the Promotion of Comprehensive Pilot Work for Expanding Service Industry Opening' (April 21)

USA's April Michigan University's 1-year and 5-year inflation expectations final value (April 25).

Note: This article has been condensed.

Authors of this article: Sun Binbin, Sui Xiuping, Min Zhixin, source: Fixed Income Binfa, original title: "Interest Rates | To Cut or Not to Cut, How Will the Market Respond?"