Investors Reassess Rate Cut Expectations in China

SHANGHAI (Reuters) – Investors are dialing back bets on near-term rate cuts in China, as the derivatives market reflects growing expectations that policymakers will refrain from easing policy in light of a weakening yuan.

Yuan interest rate swaps (IRS), widely used by domestic investors for hedging and expressing views on rates, have been inverted for nearly four weeks, with front-end yields trading above long-term yields. This inversion is driven by rising short-term rates as expectations of rate cuts diminish.

On Tuesday, the gap between five-year IRS and one-year swaps reached its most negative level in nearly a decade at minus-9 basis points.

Analysts at Commerzbank noted that, “The inversion signals that markets are dialing back expectations for People’s Bank of China (PBOC) interest rate cuts and reserve requirement ratio (RRR) adjustments.”

This situation arises amid concerns regarding yuan stability. Wider China-U.S. bond yield differentials and ongoing uncertainties surrounding U.S. trade tariffs have intensified pressure on the yuan, limiting the PBOC’s options for monetary easing.

Despite previous intentions to adopt an “appropriately loose” monetary policy in 2025 to stimulate a sluggish economy, investors are cautious, especially since the yuan has depreciated more than 3% against the dollar since the U.S. election.

Ju Wang, head of Greater China FX & Rates Strategy at BNP Paribas stated, “The next policy-rate or RRR cut is likely to follow the U.S. presidential inauguration as the central bank avoids immediate easing to defend the exchange rate.”

In light of the declining yuan, China has implemented measures including verbal warnings, adjustments to capital flows, and issuance of offshore yuan bills.

Interest rate swaps and bond futures remain key tools for those betting against rate rises in China, as short-selling bonds is not an option.

Additionally, liquidity conditions are tightening ahead of the traditional cash demand during the week-long Lunar New Year holidays. Nevertheless, the central bank has been cautious in injecting cash due to concerns about the yuan’s stability.

On Tuesday, the volume-weighted average rate of the benchmark overnight repo in the interbank market surged to 1.9636%, the highest level since June 2024.