Rate cut not here yet, will it still come?

On September 20th, the People's Bank of China announced that the 1-year and 5-year Loan Prime Rate (LPR) remained unchanged. The fact that the September LPR was not lowered does not mean the end of monetary easing. Interest rate cuts, reserve requirement ratio cuts, and continued net purchases of government bonds in the open market are still the three paths of monetary easing for the central bank this year. In our report "What does the Fed's 50BP rate cut at the beginning mean?", we emphasized that the People's Bank of China may prioritize actions to lower existing mortgage rates. Once this action is implemented, there may still be a 10-20BP reduction in policy rates within the year. The use of interest rate reduction tools may further pressure banks' net interest margins, and the central bank may use guiding deposit rate cuts in conjunction with reserve requirement ratio cuts.

Why might lowering existing mortgage rates take precedence over lowering policy rates?

Maintaining a normal upward yield curve to avoid a rapid decline in long-term bond yields. Since last week, the 10-year government bond yield has rapidly dropped below 2.1%, correcting our previous expectation of a possible rate cut in September. Prioritizing the reduction of existing mortgage rates may be a better choice because the impact of policy rates and LPR on long-term bond yields is more direct compared to existing mortgage rates. If the central bank chooses to lower policy rates and LPR in September, it may further accelerate the decline in long-term bond yields, leading to further concentration of crowded trades. The central bank's maintenance of a normal upward yield curve may have four considerations: maintaining positive investment incentives, easing bank net interest margins, guiding inflation expectations, achieving independent interest rate cuts, and avoiding monetary policy lagging behind the curve.

Lowering existing mortgage rates is beneficial for stabilizing real estate prices, promoting consumption, and aligning with the macro policy shift towards promoting consumption. According to the central bank's disclosure, the current weighted average interest rate on existing housing loans is 74BP higher than that of newly issued individual housing loans. The significant interest rate differential exacerbates early repayment behavior. Since the second quarter of 2023, the balance of individual housing loans has seen negative growth for 5 consecutive quarters, shrinking by 1.1 trillion yuan from the peak of 38.9 trillion yuan. In August 2023, the central bank already took action to lower the interest rates on existing first-home mortgages. According to the central bank, the effect of this rate cut exceeded 23 trillion yuan in existing mortgage rates, with an average reduction of 0.73 percentage points, reducing borrowers' interest expenses by approximately 170 billion yuan annually, significantly reducing early repayments and driving consumption growth. The central bank may choose a similar approach to the August 2023 rate cut, adjusting the spread of existing mortgage rates. Calculating the impact on net interest margins under two hypothetical scenarios: Scenario 1: a one-time reduction of 70BP within the year may reduce bank net interest margins by around 8BP; Scenario 2: a reduction of 35BP within the year, with the remaining 35BP achieved through repricing of existing mortgage rates next year, may reduce the central bank's net interest margins by 4BP in both this year and next year.

When will interest rate cuts and reserve requirement ratio cuts be implemented? They may wait for synergy with fiscal policies and may coincide with the introduction of incremental fiscal policies within the year. If the peak of long-term bond supply arrives, it may create favorable conditions for the central bank to increase holdings of long-term bonds. The use of interest rate reduction tools may further pressure banks' net interest margins, and the central bank may use guided deposit rate cuts and reserve requirement ratio reductions in conjunction. The reduction in reserve requirement ratio within the year may still be around 50 basis points. Based on current fiscal revenue and expenditure data, the annual budget deficit for this year may be 1.55 trillion yuan or more. The Standing Committee of the National People's Congress in October may be an important observation time point for the introduction of incremental fiscal tools. If incremental fiscal tools are introduced, government bonds are issued intensively, the central bank may increase open market operations in buying and selling government bonds as well as reserve requirement ratio reductions, working together. The reserve requirement ratio reduction is based on three factors: 1. releasing liquidity, smoothing excessive fluctuations in funds during the peak supply of government bonds; 2. the gradual increase in the amount of MLF maturing in the following months within the year, which may be partially replaced by reserve requirement ratio reductions; 3. reserve requirement ratio reductions save bank costs and alleviate pressure on net interest margins.

Government bond trading is the intersection of monetary and fiscal policies, and at the current stage, buying short and selling long to achieve net injections may be the main operating method. If the peak supply of long-term bonds arrives, it may create favorable conditions for the central bank to increase holdings of long-term bonds.

Impact on Asset Prices

10-year Treasury Yield: If China's monetary policy lands as outlined above, the 10-year Treasury yield may fluctuate around 2.0%. It is worth paying attention to whether the central bank will continue to borrow long-term bonds and the timing of selling in open market operations. This may directly affect the judgment of the scale of long-term bonds that the central bank can sell, thereby determining the central bank's guidance on the yield curve.

Exchange Rate: The Federal Reserve entered an interest rate reduction cycle in September, ending the phase of misaligned monetary policy cycles between China and the United States, relieving exchange rate pressures temporarily. Under the benchmark assumption of a soft landing in the U.S. economy, the downward pressure on the U.S. dollar is limited, and China's interest rate reduction within the year may be around 10-20 basis points, corresponding to an expected fluctuation range of around 7.1 for the Chinese yuan within the year. The current appreciation of the Chinese yuan is a rebound rather than a reversal. If the U.S. does not experience a recession, the U.S. dollar is unlikely to stabilize below 7.0 against the Chinese yuan.

Risk Warning: 1. Risks of inadequate policy understanding 2. Risks of central bank monetary policy exceeding expectations 3. Risks of government bond issuance exceeding expectations 4. Risks of the Federal Reserve's interest rate reduction exceeding expectations

Author: Zhang Jun (S0130523070003), Source: China Galaxy Macro, Original Title: "Will the Interest Rate Cut Come?"