MNI: PBOC Seen Cutting Repo Rate Soon, Boosting Bond Trades

MNI (BEIJING) - The People's Bank of China will have to cut the 7-day reverse repo rate by more than 10 basis points soon as deflationary pressure builds and real funding costs remain high across the economy, while simultaneously stepping up its government bond trades to steepen the yield curve, policy advisors, traders and ex-officials told MNI.

The PBOC is likely to act as early as this month, cutting the 7-day rate from 1.7% and guiding down the loan prime rate, policy advisors said. A delay until Q4 could endanger the government’s 5% growth target and entrench sluggish domestic demand weighed down by the troubled real-estate sector, soft investment and consumption. (See MNI: PBOC Eyes Lower Rate For GDP Target, RRR Cut Optional)

China’s economy has slowed at a faster pace than expected, with Q2 GDP growing only 0.7% q/q, increasing concern among economists and policy advisors worried about a deeper slowdown and softer domestic demand, particularly following August’s disappointing CPI and PPI data. 

Former PBOC Governor Yi Gang also fuelled concern last week by admitting the country faced deflationary pressure, a rare admission for a senior leadership figure, stressing the GDP deflator had remained negative for the past five quarters. 

YIELD-CURVE BATTLE

Bond traders, however, have bet on deflation fears for some time, which has driven the PBOC since April to warn of surging leverage in bullish fixed-income markets. 

Despite the warnings and the central bank's bond purchases last month, the 10-year CGB yield slid below 2.1% on Wednesday from early 2023’s high of 3.0%. (See MNI: Sluggish Economy To Hinder PBOC's CGB Interventions)

Market participants believe the central bank is fighting fundamentals since weak economic performance and rising expectations of further easing point to lower yields, and that the PBOC’s bond trades, in which it buys the short end and sells longer-dated CGBs to steepen the yield curve, are only delaying the inevitable trend. 

But policy advisors note the Bank wants to slow the fall of long-end yields, rather than lift them, as the economy requires lower funding costs. 

Large state-owned banks, widely seen as the PBOC’s market proxies, sold as much as CNY340 billion of 7- and 10-year CGBs in August, and unexpectedly sold a 10- year special treasury bond which had been originally purchased by the central bank in 2007. Traders are now watching whether the PBOC sells more of its CNY1.52 trillion in special treasury bond holdings to cool the market further.

Yields on one-year CGBs dropped 13bp this week, reaching a record low of 1.30%, while the 10-year fell less, as the central bank pushed to steepen the curve. However, the Bank will need to increase its bond-trade volumes over the following months to ensure continued success, advisors said.  

FISCAL FOCUS

PBOC officials think increased government borrowing remains a key solution to the current yield-curve battle. However, while market participants still expect the government to announce an additional quota of up to CNY2 trillion of special project-backed treasury bonds this year, officials are already struggling to find sufficient projects to be funded by existing quotas.

Advisors to the PBOC calculate that at least CNY5 trillion in additional fiscal funds are needed to halt deflation, but they are aware that the government’s focus on high-quality growth is likely to limit appetite for further debt.

While swifter policy rate reductions will help, these will not be sufficient to reverse the slowdown trend on their own. The PBOC’s recent cautious approach to rate cuts – it lowered the 7-day reverse repo by 10bp in July and decreased the medium-term lending facilities rate by 20bp over 2024 – also illustrates its reluctance to act rapidly due to lenders’ narrowing interest margins and the flow of bank deposits into asset management products.