Characteristics and Impacts of the Seventh Interest Rate Cut for Deposits and Loans

Event

On May 20, state-owned banks lowered the RMB deposit interest rates. Among them, the interest rate for demand deposits was reduced by 5 basis points to 0.05%; the interest rates for fixed-term deposits for three months, six months, one year, and two years were all reduced by 15 basis points, to 0.65%, 0.85%, 0.95%, and 1.05%, respectively. The three-year and five-year fixed deposits were both reduced by 25 basis points, to 1.25% and 1.3%, respectively. After this adjustment, the one-year fixed deposit rate has fallen below 1% for the first time. Meanwhile, the loan prime rate (LPR) quotes were released: the LPR for five years and above is 3.5%, and the one-year LPR is 3.0%, both down by 10 basis points.

Core Viewpoint

The first round of interest rate cuts this year has been fully implemented, showing initial results. At the press conference on May 7, titled "A Package of Financial Policies to Support Market Stability and Expectations," the central bank had already "leaked" the extent of the LPR rate cut. Currently, the LPR quotes are linked to open market operations (OMO), and deposit rates reference the LPR and the ten-year government bond yield, adjusted by banks in a market-oriented manner. The adjustment of policy rates leading to reductions in deposit and LPR rates is a customary practice in the past two years and is within expectations. Thus, the first round of interest rate cuts this year has been fully implemented. From the market operation perspective, this interest rate cut policy has achieved the expected effect. In terms of stabilizing the market, the Wind All A Index rose by 1.5% compared to the first day of the rate cut (May 7); in terms of stabilizing expectations, the May BCI corporate sales forecast index and corporate financing environment index both improved month-on-month, and it is expected that the PMI for the month will also be restored.

The asymmetric reduction in interest rates is the focus of market attention. In terms of the extent of the rate cuts, this LPR reduction is less than that in October last year (25 basis points), but the reduction in the interest rates for three-year and five-year fixed deposits is the same as that in October last year, reflecting the monetary authorities' protection of banks' net interest margins. As of the end of the first quarter, banks' net interest margin has decreased from 1.52% at the end of last year to 1.43%, setting a new historical low. Additionally, from the perspective of loan rates, the weighted average interest rate for new corporate loans in April decreased by 10 basis points compared to March, while the weighted average interest rate for new personal housing loans remained unchanged. The decline in corporate loan rates precedes the downward adjustment of policy rates and LPR, reflecting that the interest rate cut decision-making process needs to consider the interests of both the real economy and banks, aiming to "reduce the cost of bank liabilities" while "promoting a decrease in the overall financing costs for society" (Q1 Monetary Policy Report).

The level of demand deposit interest rates has approached that of major developed countries. After this rate cut, the demand deposit interest rate fell from 0.1% to 0.05%. From 2008 to 2015, the Federal Reserve lowered the federal funds rate to 0.25%, and the average interest rate for demand deposits at U.S. commercial banks was 0.05%. During the same period, the Bank of Japan also lowered the benchmark interest rate to 0.1%, leading to demand deposit rates in Japan generally falling below 0.05%. Compared to demand deposits, the current fixed deposit rates in China are significantly lower than those abroad, which is mainly related to the different economic and financial cycles between China and other countries. Due to significantly high inflation and benchmark rates in the U.S., the dollar fixed deposit rates offered by U.S. commercial banks are also at a high level, with one-year deposit rates around 3% The impact of this interest rate cut on the interest rate market. From the perspective of the effectiveness of monetary policy, the impact of the interest rate cut on the market mainly focuses on the money market, credit market, and bond market.

1. In the money market, the correlation between overnight rates and policy rates has significantly increased. Since the beginning of this year, under the guidance of "preventing fund idling and arbitrage," the basic interest rate in the money market (DR007) has tended to rise (the average rate increased from 1.68% in Q4 2024 to 1.94% in Q1 2025), and the deviation between the market basic interest rate and the policy rate has also significantly widened (the variance of DR007-OMO increased from 0.01 in Q4 2024 to 0.04 in Q1 2025). After the interest rate cut on May 7, the market basic interest rate has cumulatively declined by about 8 basis points (as of May 28), with the reduction magnitude being basically consistent with the interest rate cut, but the interest rate spread between the two remains at the 80.7% percentile over the past three years, indicating that the issue of "expensive funds" in the market has not fundamentally eased. Compared to the "rigid" performance of the market basic interest rate, the volatility of the interest rate spread between overnight rates and policy rates has decreased, and is closer to the level of the policy rate. In the first quarter of this year, the variance of the interest rate spread between DR001, SHIBOR (overnight), and the policy rate was 0.01, significantly lower than the 0.04 between DR007 and the policy rate; in absolute terms, the maximum deviation between the overnight rate and the policy rate was 46 basis points, also significantly lower than the 84 basis points of DR007. This change in the money market is significantly different from historical conditions. Over the past five years (2020-2024), the variance of DR007-OMO was 0.06, while the variance of DR001-OMO was as high as 0.15. The change of the overnight rate being closer to the policy rate may reflect an increased difficulty in predicting the central bank's liquidity injection by the market.

1. In the credit market, the long-term deposit-loan spread is expanding. Since August 2022, commercial banks have made seven adjustments to credit rates (see the table below). Overall, the decline in long-term deposit rates has been more significant. Among them, the 5-year fixed deposit rate decreased from 2.75% to 1.3%, a drop of 145 basis points; the 1-year fixed deposit rate decreased from 1.75% to 0.95%, a drop of only 80 basis points. In conjunction with loan rates, the 1-year deposit-loan spread (1-year LPR - 1-year fixed deposit rate) has remained basically stable, around 2 percentage points. In contrast, the 5-year deposit-loan spread (5-year LPR - 5-year fixed deposit rate) has shown an expanding trend. At the first interest rate cut, the 5-year deposit-loan spread was 1.65%, and after this interest rate cut, the spread expanded to 2.2%. This indicates that reducing long-term deposit rates is the main way to lower banks' liability costs, while moderately expanding the long-term deposit-loan spread is the main way to keep banks' net interest margins basically stable. According to calculations by the banking research team of China Merchants Securities ("How Much Impact Does the Spread Have"), this round of deposit benchmark rate cuts will lead to a decrease in the cost of interest-bearing liabilities for listed banks by 4.5 basis points and 2.6 basis points in 2025 and 2026, respectively In 26 years, the net interest margin contributed positively by 4.2bp and 2.4bp respectively.

1. In the bond market, deposit rates nearing the bottom may constrain the pace of interest rate declines. The relationship between deposit and loan rates and government bond yields has always attracted the attention of the market and monetary authorities due to its implications for the effectiveness of monetary policy transmission. For example, the central bank's working paper in 2016 - "The Role of the Yield Curve in Monetary Policy Transmission" pointed out: "By observing the average changes in government bond yields and spreads across various maturities on the adjustment days of the RMB deposit and loan benchmark rates compared to the previous trading day, it is found that the government bond yield curve shifts upward with the rise of the RMB deposit and loan benchmark rates and shifts downward with their decline. On average, adjustments in deposit and loan fund rates will cause synchronous changes in government bond yields." It is worth noting that the transmission between deposit and loan rates and government bond yields is not one-way; government bond yields also influence deposit and loan rates. For instance, the "Guidelines for Internal Fund Transfer Pricing of Commercial Banks" require that "the FTP curve should primarily reference market rates to accurately reflect the cost and return of funds." In practice, domestic commercial banks incorporate government bond yields into their FTP pricing models, using them as a benchmark for risk-free rates and a barometer for market rates. Additionally, the pricing mechanism for deposit rates requires banks to reference the 1-year LPR and the 10-year government bond yield for comprehensive pricing. Therefore, in terms of mechanism design, there is a linkage between deposit and loan rates and government bond yields, and in practice, since commercial banks are the main investors in the bond market, they will weigh the returns between lending and bond purchasing, forming a linkage between loan rates and government bond yields from the demand side.

Since the beginning of this year, the rapid decline in government bond yields has been initially alleviated, with the 10-year government bond yield fluctuating around 1.65%, and the yield curve further flattening. After the recent reduction in deposit and loan rates, there may be two impacts on government bond yields:

From the investor's perspective, the significant spread between deposit rates and government bond yields will drive the behavior of allocating funds to bonds, theoretically benefiting the bond market. Following this interest rate cut, major banks have set the one-year fixed deposit rate below 1%, and the five-year fixed deposit rate is around 1.3%. Compared to government bond yields (the one-year government bond yield is about 1.5%) and wealth management yields (the yield on money market funds is also around 1.5%), the cost-effectiveness is evident. It is speculated that after this interest rate cut, the enthusiasm for "deposit migration" among households will be released again, strengthening the demand side in the bond market.

From the bank's perspective, loan rates nearing the "bottom" will constrain the decline in government bond yields. For banks, the weighted average interest rate of newly issued low-risk loan products - personal housing loans was 3.1% at the end of the first quarter. After this interest rate cut, assuming it follows the LPR down by 10bp to 3%, the actual yield after considering comprehensive costs is about 1.87%. In contrast, the yield on government bonds of the same maturity (30-year government bond yield) is around 1.9%, indicating that the interest rate advantage of government bonds is not significant Looking ahead, as deposit rates have approached the "bottom," the space for loan rate declines will also be limited in order to maintain banks' reasonable net interest margin targets. This suggests that 1.87% may become a reference benchmark (i.e., "anchor") for banks' bond purchases in the near future. It is worth mentioning that the above analysis is based on a static perspective of interest rate comparisons. In practice, factors such as residents' willingness to purchase homes, capital occupation of different types of assets, liquidity, and loan issuance tasks will all influence banks' decisions to lend or purchase bonds.

In summary, the impact of this interest rate cut on the bond market is uncertain. In the short term, factors such as funding rates, the pace of government bond issuance, fundamental trends (exports, real estate, etc.), and market sentiment will all affect interest rate movements.

Conclusion and Insights:

The first round of interest rate cuts this year, which began on May 7, has been fully implemented as of the 20th. Characteristically, this interest rate cut reflects comprehensiveness, stratification, and sustainability compared to the past; in terms of impact, the signaling significance of this interest rate cut outweighs its actual significance, and its effects on major asset classes (stocks, real estate, bonds, and currencies) remain to be observed. Looking ahead, factors that may influence the next interest rate cut include export conditions, real estate performance, exchange rate trends, and government bond issuance, with a higher likelihood of implementation in the third quarter. Compared to the uncertainty of the interest rate cut pace, what is currently relatively certain is that as deposit rates approach the "bottom," the next step in lowering loan rates may primarily be achieved through policy guidance and reducing non-interest expenses; the principle of price comparison still applies, and how bond rates operate will depend on whether banks or non-bank investors will provide marginal contributions to bond market demand.

Risk Warning

The decline in the overseas economy exceeds expectations, and macro policies exceed expectations.

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