No reserve requirement ratio cut! What about interest rate cuts in January next year?

Recently, bond market interest rates have rapidly declined, accompanied by a quick rise in expectations for reserve requirement ratio (RRR) cuts and interest rate reductions. Institutions are engaging in front-running trades. Regarding the understanding of loose monetary policy and the realization of the dual cuts, we believe there are several key points to focus on:

The market's expectation of a 25 basis point RRR cut within the year may have already fallen through. The comprehensive incremental monetary policy package announced on September 24 mentioned that "depending on the liquidity conditions in the market, the central bank may choose to further lower the reserve requirement ratio by 0.25-0.5 percentage points within this year." During the December Politburo meeting, "moderate easing" was mentioned again after more than ten years, leading to heightened expectations for RRR cuts and interest rate reductions. Coupled with institutional front-running, the bond market has preemptively priced in the dual cuts, resulting in a rapid decline in interest rates. By December 20, the 10-year government bond yield had reached the 1.70% mark. However, from the current situation, as the year-end approaches, the market's expectation for another RRR cut this year may have already fallen through.

Looking back, a similar situation occurred in 2020. For example, in April 2020, the Politburo meeting mentioned RRR cuts and interest rate reductions, stating that "the prudent monetary policy will be more flexible and appropriate, using methods such as RRR cuts, interest rate reductions, and relending to maintain reasonable and ample liquidity." However, in reality, the dual cuts did not materialize in May, and with the stabilization of the economic fundamentals, market sentiment was disturbed, causing the 10-year government bond yield to rise from a low of 2.48% in early April 2020.

Furthermore, we believe that moderate easing of monetary policy may focus more on the means rather than the extent. Based on the existing situation, a rate cut in January next year may also fall short of expectations, which could put pressure on trading positions. Specifically, regarding monetary policy, the necessity for a significant increase in easing in the short term is relatively limited:

1. Market liquidity is relatively ample, and the probability of significant injections is low: From the results of the MLF (Medium-term Lending Facility) operations in December, the maturity of 1.45 trillion yuan on December 16 was significantly reduced to 300 billion yuan on the 25th, which may indicate that the central bank's judgment on the overall liquidity in the market is "ample." In terms of funding rates, as of December 24, the DR007 has also fallen from a high level to around 1.5%.

2. Economic and financial data performance is not bad, with some marginal improvements: The year-on-year growth rate of M1 in November rebounded, with the decline further narrowing to 3.70%. From a trend perspective, the lowest point may have passed; the manufacturing PMI has risen for three consecutive months, now above the expansion line; the year-on-year sales of commercial housing in October-November showed significant improvement, with November recovering to a positive range of 1.0%.

3. The equity market has not shown significant corrections: Since December, the Shanghai Composite Index has basically fluctuated around 3400.

It is important to note that there are many instances of institutions using configuration stories for trading in the current trading logic, which may carry certain risks. In the current market where long bond rates are rapidly breaking through low points, configuration-type institutions with certain liability costs (such as brokerages and insurance companies) are placing more emphasis on FVOCI (Fair Value Through Other Comprehensive Income) measured financial asset investments. Analogous to bond market investors, there is also a trading logic of using OCI stories for fair value investments. However, the investment logic of trading and configuration itself is different, and following the configuration approach for trading carries certain risks For the bond market, the long-term bullish trend remains unchanged. We maintain the 10Y government bond yield target level of 1.6%-1.9% for next year, but short-term pullback risks also need to be monitored. Especially on the monetary policy front, the pricing for interest rate cuts has already advanced significantly, but we believe that both equity performance and economic data are relatively strong. Looking ahead to next year, external policy responses may be the main source of domestic policy intensification. The necessity for short-term monetary policy easing is not strong; "moderate easing" may focus more on means rather than magnitude. For the short end, the previous self-discipline initiative has clearly included non-bank demand deposit rates under self-discipline management. If the 7-day reverse repo rate is taken as the upper limit, interbank deposit rates may fall to 1.5% or below. The market's expectation for a decline in short-term certificate of deposit rates at the end of the year and the beginning of the next year is heating up, but attention should also be paid to the increase in certificate of deposit supply at the beginning of next year, which may not necessarily lead to a convergence of rates towards 1.5% and could widen instead.

Article authors: Lü Pin S0120524050005, Yan Lingyi S0120524110003, Source: Debon Securities, Original title: "How will the bond market perform without a reserve requirement ratio cut?"

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