No interest rate cut, better

Since April, the intensification of trade friction has led bond yields to return to a downward trend. The market has strong expectations for future interest rate cuts and reserve requirement ratio reductions, suggesting that only with the implementation of these measures can interest rates open up downward space. We do not deny that interest rate cuts and reserve requirement ratio reductions can boost market bullish sentiment, but we believe that the bond market has never been driven by these measures; as long as the economy is in a downturn, bond yields should decline.

On one hand, we believe that whether or not to cut the reserve requirement ratio is not that important. Regardless of whether the reserve requirement ratio is cut, the key factor for interest rates to decline is whether the repurchase rate can decrease. On the other hand, based on several phenomena observed in the first quarter, interest rate cuts do not necessarily bring about changes that are favorable for bonds. Let's analyze the issue of interest rate cuts in detail.

First, generally speaking, a complete interest rate cut process includes the decline of OMO rates, deposit rates, and LPR rates. After all, the purpose of cutting interest rates is to drive down loan rates, which cannot be separated from the decline of LPR rates. Under the pressure of declining bank net interest margins, the decline of LPR also requires a decrease in deposit rates and OMO rates to alleviate the downward pressure on banks' interest margins. However, even so, during the interest rate cut process, due to the greater sensitivity of loan rates to declines and the more resistant nature of deposit rates, banks' net interest margins continue to decline throughout the interest rate cut process.

However, we must also recognize that while the decline in bank net interest margins is not good for banks, it is beneficial for the real economy: a decrease in loan rates essentially means that banks are subsidizing the real economy; a slower decline in deposit rates means that banks are subsidizing depositors (including corporate depositors). Therefore, essentially speaking, the decline in bank net interest margins is still favorable for the real economy. Thus, we see that in the first quarter, banks' overall profits declined rapidly, but the profit growth rate of industrial enterprises returned to positive (the same applies to listed companies; in the first quarter, excluding banks, the profits of listed companies were also positive).

Therefore, to some extent, interest rate cuts are beneficial for the economy. So, if interest rate cuts can lead to economic improvement, then are interest rate cuts ultimately favorable or unfavorable for bonds? Perhaps in the short term, they are favorable; in the medium term, they may be unfavorable.

Second, interest rate cuts lead to a decline in bank net interest margins, and the subsequent two changes are unfavorable for bonds:

(1) After the decline in bank net interest margins, in order to ensure that bank profits do not decline too much, many banks chose to realize bond profits in the first quarter. Therefore, at the end of the first quarter, banks selling bonds was one of the main reasons for the rise in interest rates. If interest rates continue to decline in the future, the decline in bank net interest margins will again motivate banks to sell bonds to supplement profits at the end of the second quarter, which will put pressure on bonds.

(2) After the decline in bank net interest margins, there will be increased pressure on banks to replenish capital, which increases the pressure on fiscal issuance of special government bonds to help banks replenish capital. This is also not good for the bond market, as it increases the supply of special government bonds. It also means that the bond market is providing funds to replenish banks' capital.

Third, the issue of exchange rates. If the Fed cuts interest rates and we follow suit, the pressure on the exchange rate will be somewhat reduced. So, is the Fed likely to cut interest rates soon? We believe not necessarily. Although the U.S. GDP showed negative growth in the first quarter, consumer spending remained relatively stable. The negative growth in the economy was mainly due to U.S. companies rushing to import in the first quarter, leading to a significant drag on GDP from net exports This can also be verified from our data: the U.S. grabs imports = we grab exports, so our export growth rate was relatively high in the first quarter. Since April, after the escalation of trade frictions, the situation of additional imports by the U.S. has not continued, so the drag of net exports on U.S. GDP has also ceased. On the other hand, the inflation rebound pressure in the U.S. remains significant. Therefore, the probability of the Fed cutting interest rates in the short term is low. If the Fed does not cut rates while we do, it will lead to increased pressure for currency depreciation, which will also offset the downward effect of rate cuts on interest rates to some extent.

Fourth, from the perspective of market sentiment, will a rate cut lead to a complete positive effect? It is highly likely. After all, current interest rates are not high, and in addition, banks still need to achieve bond profits in the second quarter to subsidize profit gaps. If a rate cut is realized, institutions will have the motivation to reduce their bond holdings.

If there is no rate cut in the short term but economic data continues to be weak, bond yields will inevitably decline. Of course, in this case, short-term rates will be constrained by the unfulfilled rate cut and will not go down; long-term rates will decline faster, leading to a flattening of the yield curve.

If a rate cut is ultimately realized, short-term rates will decline accordingly, and the curve will shift from flat to steep, ending the downward trend in bond yields. Moreover, a rate cut will lead to a continued decline in banks' net interest margins, and banks will further pass on benefits to the real economy, which will lead to increased bond selling to realize profits; especially, the issuance of government bonds to supplement banks' capital requirements will become more urgent. These changes will also be unfavorable for bonds.

Therefore, considering the pros and cons, if there is no rate cut, it is more favorable for the downward trend of bond yields.

Author of this article: Zhu Dejian, Source: Qu Qing Bond Forum, Original Title: "No Rate Cut, Better"

Zhu Dejian SAC: S0360622080006

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