The unique "cutting" heart of the central bank in July

After considering multiple targets such as preventing air turning, stabilizing interest rate differentials, and stabilizing exchange rates in the first half of the year, the monetary policy saw an important change at the beginning of the second half of the year: the 7-day reverse repurchase rate, 1-year LPR, and 5-year LPR all decreased by 10 basis points. There may be two underlying meanings behind this move: first, amidst continuous changes in the domestic and international environment, the monetary policy objectives have entered a new stage focusing on the domestic front; second, a new interest rate transmission system is emerging, and a new monetary policy framework is evolving.

The timing of the interest rate cut in July was just right. Firstly, external pressures have eased. Since the second quarter, both U.S. inflation and labor market have significantly weakened. The market currently believes that the Fed's rate cut in September is "a foregone conclusion," objectively increasing the domestic monetary policy space. Secondly, the necessity of an interest rate cut has increased. With GDP growth at 4.7% in the second quarter, slightly lower than the first quarter, considering the increasing pressure on exports in the second half of the year, the current necessity of policy support for the economy has increased, making an interest rate cut reasonable at this point.

The interest rate cut in July marks a "fresh start" for the interest rate transmission mechanism. Since the LPR reform in 2019, the pattern of interest rate cuts has often been the 7-day reverse repurchase rate and MLF rate first, followed by adjustments to the LPR. This time, the 7-day reverse repurchase rate, 1-year LPR, and 5-year LPR were all lowered by 10 basis points simultaneously. Combining this with Governor Pan Gongsheng's previous mention of "clearly taking a short-term operating rate of the central bank as the main policy rate, currently, the 7-day reverse repurchase rate has basically assumed this function." Today, the central bank's operation may have provided an answer to the LPR reform—the benchmark referenced by the LPR may have shifted from the previous one-year MLF rate to the 7-day reverse repurchase rate.

Referring to the three pricing mechanisms of overseas LPR, the central bank's move is also a "necessary path" for interest rates to move towards marketization:

First is pricing based on bank costs. Like India's Marginal Cost of Funds Based Lending Rate (MCLR), which mainly considers bank funding costs, cash reserve ratio, and term premiums. The advantage is that it can maintain the relative stability of bank interest rate differentials, but the degree of marketization is lower, making it less responsive to changes in central bank policy rates.

Second is linked to short-term policy rates. Like the U.S.'s Prime Rate, which has been basically fixed at the federal funds target rate +300 basis points for nearly 30 years. However, as the pricing of U.S. loans diversifies, this mechanism is more used in pricing small business loans.

Third is determined by money market rates. Like Japan's long-term loan rates, where commercial banks have more pricing autonomy, mainly focusing on currency market rates such as Tibor. There is a greater risk of volatility, but it can better reflect market prices and become the main pricing basis for large corporate loans

Apart from interest rate cuts, what is the mystery behind the OMO opening up quantity bidding? Different from the previous central bank's mainly interest rate bidding and the active control of the scale of reverse repurchase injection, today's OMO bidding has been adjusted to fixed interest rates and quantity bidding. The injection amount (58.2 billion yuan) also breaks the previous "10 billion unit" "policy paradigm", more determined by the demand of traders, and the mechanism is closer to the European Central Bank's main refinancing tool (MRO) fixed interest rate, unlimited quantity model. We believe that the "market-oriented" nature of the central bank's future reverse repurchase operations will undoubtedly be stronger.

From subtle changes, what does the adjustment of the interest rate mechanism mean? First, the observation window for interest rate cuts has changed, possibly shifting from the "MLF operation" on the 15th of each month to the "LPR operation" on the 20th, but it does not rule out the central bank adjusting interest rates in the daily reverse repurchase announcements; second, the policy significance of MLF interest rates is further diluted, and future operations as supplementary medium- to long-term liquidity tools will mainly focus on quantity; third, we need to be vigilant about bond market fluctuations. The central bank's decision to appropriately reduce the collateral for MLF operations is also a kind of "selling bonds" behavior, intentionally correcting the excessive downward trend of bond yields.

Author: Tao Chuan S0600520050002, Wu Bin, Zhao Honghe, Source: Chuan Yue Global Macro, Original Title: "The Central Bank's 'Cutting' in July"