China’s Surprise Rate Cut Sparks Drop in Key Bond Yield and Yuan

The recent surprise rate cut by the People’s Bank of China (PBOC) has sent shockwaves through the Chinese market. The aim was to stimulate economic growth, but it has led to unintended consequences. The benchmark government bond yield has plummeted to a three-year low, and the yuan has weakened. This decline in bond yields and the currency indicates growing concerns about Chinese assets and the urgent need for further stimulus measures to revive growth.

The PBOC’s decision to lower one-year loan rates by 15 basis points to 2.5% caught many off guard. This announcement came just moments before the release of disappointing economic data, including weaker-than-expected retail sales and fixed-asset investment figures. These factors have exacerbated market sentiment and emphasized the necessity for additional fiscal and monetary measures to support the economy.

Experts suggest that the impact of the rate cut on growth hinges on whether the positive effects of lower rates outweigh the challenges posed by wider rate spreads between China and the US. To regain market confidence, Beijing must demonstrate a commitment to increased spending and further monetary easing, such as reducing banks’ required reserve ratio.

The yield on China’s 10-year bonds has dropped five basis points to 2.57%, reaching levels not seen since the height of the pandemic in April 2020. Concurrently, the yuan has weakened both onshore and offshore, hitting its lowest level since November. The continuous decline in Chinese stocks adds to the overall negative sentiment.

China has implemented various measures to boost confidence in the yuan, but the impact has been limited so far. The PBOC has set a daily reference rate for the currency that deviated significantly from expectations, and an additional bill sale in Hong Kong has been announced to provide support. Some state-owned Chinese banks have been observed selling dollars in the onshore market to stabilize the yuan. However, the onshore yuan still trades at a significant discount to the official reference rate, nearing the lower end of its trading band with the US dollar.

Analysts predict that the dollar-yuan spot rate may reach levels above 7.3 in the near future, while the 10-year yield could reach 2.5% to 2.55% in the coming weeks. This aggressive rate cut underscores the need for further measures to support credit growth and stabilize the market.

Despite the challenges, the PBOC has additional tools at its disposal to stem the decline in the yuan if necessary. It can strengthen its support through the daily fixing and provide more dollar liquidity by reducing foreign exchange reserves for banks. The central bank has already made adjustments to allow more inflows in July.

However, analysts caution that the yuan may continue to face headwinds due to weak economic data and a widening yield gap. While the PBOC may attempt to mitigate volatility, it is unlikely to establish a definitive stance as market conditions remain uncertain.