Did the central bank cut interest rates beyond expectations? Will MLF and LPR follow suit next?

On June 13th, the People's Bank of China conducted a 7-day reverse repurchase operation of 2 billion yuan through an interest rate bidding method, with the winning bid rate dropping by 10 basis points to 1.90%. This is the first time in 10 months that the 7-day reverse repurchase rate, which serves as the short-term policy rate of the central bank's open market operations, has been lowered.

Analysts pointed out that the synchronous downward adjustment of the subsequent interest rate system is the general trend, and it is now the turn of MLF and LPR. The mid-term policy rate of the Medium-term Lending Facility (MLF) on June 15th and the Loan Prime Rate (LPR) on June 20th are also expected to follow the central bank's unexpected "interest rate cut".

Interest rate cut "reasonable but unexpected"

The fixed income team of CICC Securities pointed out that the increasing pressure of economic MoM decline + weak demand for real financing + rising risk of local government debt make interest rate cuts a policy option. This interest rate cut is "reasonable but unexpected":

1. Currently, China is in a macro environment where the pressure of economic MoM decline is increasing, real financing demand is weak, and the risk of local government debt is rising. The internal driving force of the economy is insufficient and policy support is needed. Interest rate cuts are a policy option, and market expectations for interest rate cuts began to rise significantly last Friday, so the interest rate cut is reasonable.

2. However, the timing and method of the interest rate cut seem somewhat "unexpected".

On the one hand, the mainstream of market expectations and games is the MLF interest rate cut. The timing of this interest rate cut is ahead of the MLF renewal point, and the method is to directly adjust the OMO interest rate, which is one of the "unexpected" factors;

On the other hand, some investors in the market previously judged that the conditions for an interest rate cut in June were not mature and the probability of an interest rate cut was not high. The time window for an interest rate cut may have to wait until July-August. The timing of this interest rate cut is obviously ahead of the judgment of these investors, which is another "unexpected" factor.

The fixed income team of CICC Securities believes that this interest rate cut may indicate that the demand for real financing is weaker than expected by the policy, and the OMO interest rate cut may be a bigger positive than the MLF interest rate cut:

From the experience of the past two times, the central bank often chooses the MLF renewal point for interest rate cuts, and the method is to synchronously adjust the MLF and OMO interest rates (refer to January and August 2022).

Currently, it is close to the MLF renewal point, but the central bank directly adjusts the OMO interest rate. This may indicate that: 1) the current real financing demand is significantly weaker than expected by the policy; 2) the interest rate cut seems to be urgent. Therefore, we believe that for the bond market, this OMO interest rate cut may be a bigger positive than the MLF interest rate cut.

Huajin Securities pointed out that this interest rate cut confirms their structural analysis of the current economic downturn pressure, that is, the weak wealth effect expectation of the middle and high-income groups due to the bottoming out of the real estate cycle is the main reason for insufficient domestic demand, and the low and middle-income groups urgently need monetary easing operations to promote infrastructure investment, stabilize employment and expand income:

From a mid-term perspective, the 7-day reverse repurchase rate is closely related to MLF and LPR, and has always been the key target of interest rate policy adjustments that are most advanced and have a chain reaction. Its changes are closely related to the performance of macroeconomic structure.

The expectation of interest rate cuts has been effectively realized, which confirms our structural prediction since the beginning of this year that domestic demand is still insufficient.

The macro team of Dongwu Securities believes that the central bank's interest rate cut today came a bit fast, but the central bank's quick action this time is no exception:

When the market's consensus expectation was turning to the MLF interest rate cut on June 15 (also the day when economic data was released), the central bank took the lead in cutting the 7-day OMO interest rate today.

We believe that this move is unusual. As shown in Figure 1, the central bank usually cuts the MLF and OMO interest rates on the same day. The last time the OMO interest rate was raised before the MLF interest rate cut was during the outbreak of the epidemic in 2020, highlighting the urgency of policy quick action to cope with the economic downturn. After the central bank's quick action, a package of measures to stabilize the economy, represented by real estate and infrastructure, followed.

As we have stated in our previous report, historical experience shows that once the PMI falls below 50 for consecutive months and the YoY growth rate of exports falls below -5%, policies will often take quick action to respond. This not only includes monetary policy interest rate cuts and reserve requirement ratio reductions, but also includes the relaxation of real estate regulation and the increase of infrastructure investment.

Before this interest rate cut, Governor Yi Gang had emphasized in his Shanghai research last week that the central bank will "strengthen countercyclical adjustments and fully support the real economy" in the next step. It can be seen that while monetary policy is beginning to "fully" support the real economy, other overall policies also need to coordinate and cooperate to form a "joint force".

The window for policy intensification may be opening

The macro team of CITIC Securities believes that this reverse repo interest rate cut may mark the opening of the window for policy intensification.

The macro team of CITIC Securities pointed out that since April, the economic recovery has slowed down, the inflation rate has fallen, and credit growth has been weak. The interest rate cut is timely. There are three main reasons for this reverse repo interest rate cut:

First, due to the decline in real estate sales and the fading of the dividend of the lifting of consumption restrictions, China's economy has slowed down since April, and the PMI has been below the boom-bust line for two consecutive months in April and May.

Second, the recent CPI and PPI growth rates have clearly fallen back, with a YoY increase of 0.2% for CPI and a YoY decrease of 4.6% for PPI in May. The decline in prices reflects that insufficient demand is the main problem in the current economy, and the decline in prices also leads to a passive increase in real interest rates.

Third, credit issuance in April has significantly cooled down, and resident loans have reappeared with negative growth. Judging from the bill interest rate, credit issuance in May may also be low.

The last time the 7-day reverse repo interest rate of open market operations was lowered was on August 15, 2022. At that time, the central bank simultaneously lowered the 1-year MLF interest rate and the 7-day reverse repo bid rate by 10 basis points. The policy interest rate and LPR were not adjusted until June 13, when the 7-day reverse repo interest rate was lowered.

The MLF and LPR rates in June are likely to follow a downward trend

After the short-term policy rate cut, it is widely expected that the MLF and LPR rates in June will follow suit.

CITIC Securities believes that both the MLF and LPR rates in June will follow a downward trend, with the MLF rate possibly decreasing by 10bp and the LPR rate having the possibility of asymmetric downward adjustment, with the 5-year LPR rate possibly having a larger decrease:

Historically, the MLF and reverse repo rates have often been adjusted synchronously and by the same magnitude. It is expected that the rate will also be lowered by 10bp when the MLF expires on June 15. Since the LPR is quoted on top of the MLF rate, it is highly likely that the LPR will follow suit after the MLF rate cut.

Considering the current sluggishness of real estate sales, the 5-year LPR rate may be lowered by more than 10bp to further reduce mortgage rates and promote stable and healthy development of the real estate market.

Wang Qing, chief macro analyst at Dongfang Jincheng, believes that considering the general rule of linkage adjustment of the policy rate system, the medium-term policy rate (MLF operation rate) will also follow suit after the short-term policy rate cut. At the same time, since the MLF operation rate is the pricing basis for LPR quotation, if the MLF operation rate is lowered in June, the LPR quotation on June 20 will also follow suit:

Considering that the current corporate loan rate is already at a historical low and significantly lower than the residential mortgage rate, coupled with the recent weakness in the property market, we judge that the 1-year LPR quotation and the 5-year and above LPR quotation this month are likely to have asymmetric downward adjustments, with the 1-year LPR quotation possibly decreasing by 5bp (0.05 percentage points) and the 5-year and above LPR quotation decreasing by 15bp (0.15 percentage points).

Huajin Securities predicts that the MLF and 1-year LPR rates will be lowered by a larger margin to repair the interest rate spread, and the 5-year LPR rate will be lowered but with less force than the 1-year rate to promote investment. It is expected that there will be further reserve requirement ratio cuts in the future to complement the interest rate cuts:

The forecast for the whole year is a 20-30bp decrease in the 1-year LPR/MLF and a 10-15bp decrease in the 5-year LPR, with the latter having a smaller decrease than the former.

Interest rate cuts may drive the acceleration of medium- and long-term corporate loans, and low-cost and efficient liquidity injection operations are needed to complement them. The outlook for the whole year is to maintain a 100bp reduction in the reserve requirement ratio and a 25bp reduction every quarter.

The synchronous downward movement of the subsequent interest rate system is the general trend in the fixed income market. It is highly likely that the MLF and LPR rates in June will follow the OMO rate cut synchronously (the LPR rate cut may even exceed 10bp), and the probability of subsequent system-wide deposit rate cuts is also increasing.

Dongwu Securities predicts that the MLF rate in June will follow the OMO rate cut, but there is a possibility of an unexpected downward adjustment in the LPR rate, and it is not ruled out that the MLF and LPR rates may be lowered by more than 10bp:

Especially since Q2, the pressure on the real estate sector has increased: firstly, the willingness of residents to purchase houses has rapidly declined, and the early repayment rate of mortgages remains high; secondly, since May, the sales of real estate have continued to decline MoM, and house prices have returned to a downward trend. In addition, this year's new construction has fallen into a shrinking range. It is not ruled out that the MLF and LPR interest rates may be lowered by more than 10bp in June to timely curb the situation of real estate spiraling down in the second half of last year.