On September 20, the central bank announced that the 1-year and 5-year LPR prime rates remained unchanged. The fact that the LPR was not lowered in September cannot be regarded as the end of monetary easing, and interest rate cuts, RRR cuts, and net purchases of treasury bonds in the open market are still the three paths of the central bank's easing during the year.

The People's Bank of China (PBOC) is likely to prioritize lowering interest rates on existing mortgages. After the action is implemented, the policy rate may still be cut by 10-20BP within the year. The use of the rate cut tool may put further pressure on banks' net interest margins, and the central bank may use the guidance deposit rate cut in conjunction with the RRR cut.

|LPR is expected to be further reduced?

Holding a normal upward slope yield curve to avoid a rapid decline in long-term bond yields is a key focus of current financial management. Recently, the yield on the 10-year Treasury note has fallen rapidly below 2.1%, revising previous expectations that the policy rate may be cut in September. In contrast, it may be a better option to prioritize the adjustment of existing mortgage rates. This is because the policy rate and LPR have a more direct impact on long-term bond yields than the interest rate on existing mortgages.

If the PBOC chooses to cut the policy rate and LPR in September, it could further accelerate the decline in long-term bond rates, leading to an overconcentration of market trading. The central bank's purpose of keeping the yield curve on track is likely to include four aspects: ensuring positive incentives for investment, reducing pressure on banks' net interest margins, guiding reasonable inflation expectations, and achieving orderly interest rate cuts to prevent monetary policy from lagging behind the economic situation.

Adjusting the interest rate of existing housing loans will help stabilize the real estate market price, thereby stimulating consumption, which is in line with the direction of the current macro policy to promote consumption. According to central bank data, the current weighted average interest rate on existing housing loans is about 74 basis points higher than the interest rate on new personal housing loans. This wide spread has led to an increase in prepayments, with the balance of personal housing loans showing negative growth for five consecutive quarters since the second quarter of 2023, from a peak of 38.9 trillion yuan to a cumulative contraction of 1.1 trillion yuan.

The impact on banks' net interest margins is estimated according to two different scenarios: the first is a one-time reduction of 70 basis points during the year, which could result in a reduction of about 8 basis points in the bank's net interest margin; The second option would be to cut the bank by 35 basis points this year, and the remaining 35 basis points will be realized next year through the repricing of existing mortgage rates, which could reduce banks' net interest margins by about 4 basis points this year and next year.

When will interest rate cuts and RRR cuts land?

With the arrival of the peak period of long-term government bond supply, this may create favorable conditions for the central bank to increase its holdings of long-term government bonds.

The use of interest rate cuts may further compress banks' net interest margins, so the PBOC may use a combination of guided deposit rate cuts and RRR cuts. It is expected that the RRR cut may reach 50 basis points within the year. According to the current fiscal revenue and expenditure data, the annual budget revenue and expenditure gap is expected to exceed 1.55 trillion yuan, and the meeting of the Standing Committee of the National People's Congress in October will be an important time node to observe whether incremental fiscal tools are introduced. Once the incremental fiscal tools are launched, along with the intensive issuance of government bonds, the central bank may increase the trading of treasury bonds in the open market and cut the reserve requirement ratio to form a policy synergy.

There are three factors to consider for the RRR cut: first, to release liquidity to stabilize capital fluctuations during the peak supply of government bonds; Second, considering the gradual increase in the maturity of medium-term lending facilities (MLFs) in the subsequent months of the year, part of the mature MLFs can be replaced by RRR cuts; Third, the RRR cut can reduce the cost of banks and ease the pressure on net interest margins.

Treasury bond trading is a key link at the intersection of monetary policy and fiscal policy, and the central bank may adopt the main operational strategy of buying short-term treasury bonds and selling long-term treasury bonds and achieving net supply at this stage. With the arrival of the peak period of long-term treasury bond supply, the operating environment for the central bank to increase its holdings of long-term treasury bonds may be improved.

Analysis of Treasury yields and exchange rate trends

If China's monetary policy is implemented as previously described, then the 10-year yield is likely to fluctuate around 2.0%. The next question to watch is whether the central bank will continue to conduct open market operations by borrowing long-term Treasuries and selling them at the right time. This approach will directly affect the amount of long-term Treasury bonds available for sale in the hands of the central bank, which in turn will determine the central bank's ability to regulate the yield curve.

On the exchange rate front, the dislocation of the monetary policy cycle between China and the United States will temporarily end as the Federal Reserve is expected to begin its interest rate cut cycle in September, thereby easing the exchange rate pressure on the RMB.

Based on the assumption that the United States economy is expected to achieve a soft landing, the room for the dollar to depreciate is expected to be limited. Against this backdrop, China is likely to cut interest rates by another 10 to 20 basis points this year, which will put the center of the renminbi's exchange rate fluctuations roughly at the 7.1 level throughout the year. It should be noted that the current round of RMB appreciation is more of a rebound than a trend reversal; As long as the United States economy avoids a recession, it will be difficult for the USD/RMB exchange rate to remain below 7.0.