The recovery of the economy is anticipated to be significantly slower compared to the rebound observed in 2020. The monetary policy environment is expected to remain lenient for an extended period, with interest rates sustained at low levels until both corporate and household financing demand normalizesThis cautious outlook stems from lingering concerns over economic growth dynamics.

On August 15, the central bank took decisive measures by lowering the 7-day reverse repurchase rate and the Medium-term Lending Facility (MLF) rate by 10 basis pointsFollowing this, the Loan Prime Rate (LPR) for loans of one year and over five years was asymmetrically adjusted downward again, causing a decline in government bond yields to their lowest levels for the yearThe market is currently grappling with significant profit-taking pressure, which leads to varying interpretations regarding the future direction of monetary policy.

Despite reductions in policy rates, the transmission of a looser monetary policy into more accessible credit continues to face challenges

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The intrinsic momentum for economic growth appears weak, suggesting that further interest rate cuts might still be possible in the fourth quarterHence, it is unnecessary to overly fret about an imminent turning point for rising rates.

Since 2022, the monetary policy has consistently leaned towards accommodationFrom a quantitative perspective, a reserve requirement ratio cut of 0.25 percentage points occurred in April, and as of the end of July, 1 trillion yuan of retained profits were transferred into the banking system, which is equivalent to an approximate overall 0.5 percentage points of additional liquidity being injectedMoreover, from a qualitative angle, key policy rates such as the 7-day reverse repurchase rate, the one-year MLF rate, as well as LPRs for both one year and above five years, have all decreased significantly.

The combination of the central bank's accommodative stance and the overall weak demand for financing has generated a scenario of "asset scarcity," resulting in a substantial decline in market interest rates

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The level of liquidity in the financial system has not only exceeded market expectations but also persisted for longer durationsRates such as the DR001 even reached the 1% mark, while the DR007 dropped as low as 1.29%. Interbank Certificate of Deposit (CD) rates also witnessed a drop of nearly 70 basis points, marking a new low since May 2020. The long-end pricing of bonds has been cautious, influenced by policies aiming to stabilize economic growth, leading to a steepening yield curve decline.

The three asymmetric LPR reductions since 2022 suggest a clear shift in policy attitudes towards the real estate sectorThe LPR for periods over five years has dropped 20 basis points more than that for one year, narrowing the spread between the two considerably to just 65 basis points—close to historical lowsThis decrease in the LPR has consequently reduced the weighted average interest rate on loans by 35 basis points compared to the end of last year, hitting a record low of 4.41%. By the end of the second quarter, personal mortgage rates had dropped by 101 basis points to 4.62%, falling below general loan interest rates for the first time since 2020.

Expectations of further rate cuts persist into the fourth quarter

The central bank's monetary policy execution report for the second quarter stressed the need to avoid excessive monetary supply, cautioning against "flood-like" liquidity injections

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The market's overall expectations for significant monetary easing remain tepidShort-term, it seems unlikely that more rate cuts will occur while the benefits of the existing measures are still being evaluatedHowever, there remains room for the MLF and LPR adjustments in the fourth quarter, particularly if domestic economic recovery does not meet expectations or unforeseen events occur in the real estate sector.

From the perspective of the necessity for interest rate cuts, the prevailing real estate conditions and pandemic-related issues are the two most influential macroeconomic variables affecting China's economic trajectoryChanges in these areas will determine the slope of credit recovery, consequently posing the question of whether lower rates are necessary to revive aggregate demandReal estate-related industries contribute roughly 30% to GDP; thus, a decline in industry activity adversely impacts interconnected corporate sectors, lending practices, and ultimately, the government’s fiscal revenue.

Since the second quarter, the interplay of real estate and pandemic risks has stifled the transmission of credit

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In July, non-financial corporate loans shrank by 145.7 billion yuan year-over-year, while household loans decreased by 284.2 billion yuanConcurrently, the difference in year-on-year growth rates for M2 and social financing widened to 1.1%, illustrating sluggish financing demand in the real economyDespite the LPR adjustment in August—allowing the initial and secondary personal housing loan rates to reach as low as 4.1% and 4.9%, respectively—recent data shows that housing transactions in major cities remain depressed, indicating that consumer sensitivity to interest rate reductions may be waning.

Conversely, from a feasibility standpoint regarding rate reductions, any further lowering of the LPR hinges on adjustments to deposit ratesUnder the current framework for market-based deposit rate adjustments, banks must consider prevailing rates in bond markets, such as the 10-year government bond yield and the one-year LPR, which shapes how they set deposit rates

The national financial institutions' new average deposit rate recently stood at 2.37%, with the 10-year bond yield dropping over 20 basis points since AprilWhile the one-year LPR has also seen reductions, banks have yet to alter deposit rates accordingly, which could impede any sustained downward trend in LPR.

Analyzing the future trajectory of interest rates reveals that despite the extensive current gap between the 7-day reverse repurchase rate and the DR007—where the former remains significantly elevated at 2%—the August rate cut did not further lower liquidity ratesFuture adjustments to the 7-day reverse repo and MLF rates might yield limited effects on funding ratesGoing forward, liquidity is projected to remain loose, yet with the government steps in place to enhance growth, the situation might improve, with overnight and 7-day repo rates expected to stabilize in the lower range.

The central bank's rate cuts in February and April 2020 inspired a cumulative reduction in the 10-year government bond yield of 40 basis points

As of August 22, the yield has decreased by 14 basis points since mid-AugustPresently, the yield spread between 10-1 year government bonds exceeds 80 basis points, indicating potential for compression relative to the average seen over the past three yearsWith the overall downward trend in interest rates and extending durations providing opportunity for enhanced investment returns, there remains motivation for a flattening of the yield curveCurrently, the distance to the recent low of 2.50% on April 29, 2020, stands at merely 9 basis points.

Due to the persistent risks posed by the real estate and pandemic sectors, the recovery of the economy is likely to be markedly slower than in 2020. The expectation remains that the monetary policy environment will continue to maintain lower rates for an extended period, up until enterprise and household financing demands find a normalized trajectory