(Bloomberg) -- China traders are rushing to the safest assets the market has to offer, as a surprise interest-rate cut failed to repair confidence damaged by ongoing economic weakness.

The benchmark government bond yield dropped to a three-year low, while the yuan and local stocks sank in tandem, as disappointing economic data followed quickly on the heels of the People’s Bank of China’s unexpected move. That’s a sign of worsening sentiment toward Chinese assets and a market begging for more stimulus to rejuvenate growth.

The PBOC is walking a fine line — it needs to ease monetary policy to an extent that’s sufficient to boost growth but not enough to send the yuan tumbling because of China’s yawning rate divergence with the US. What the country needs is more fiscal stimulus and further monetary loosening such as a cut to banks’ required reserve ratio, according to analysts. 

It was “a big move by the PBOC and for the yuan and the question from here is whether the growth and stimulatory aspect from lower rates outweighs the headwinds from wider US-China rate spreads,” said Rodrigo Catril, currency strategist at National Australia Bank. “Beijing still needs to show some spending commitments to convince markets a turn in fortunes is in the offing.”

The PBOC lowered the rate on one-year loans by 15 basis points to 2.5% on Tuesday and it also cut a short-term policy rate. That came just minutes before a slew of weaker-than-expected data — including keenly watched retail sales and fixed-asset investment figures — further dented sentiment.

China Cuts Rate by Most Since 2020 as Economic Woes Deepen

The yield on China’s 10-year bonds dropped five basis points to 2.57%, a level unseen since the height of the pandemic in April 2020. The yuan weakened in both onshore and offshore trading to the lowest since November, while a gauge of Chinese stocks declined for a third straight day. 

China is deploying a slew of measures to restore confidence in the yuan, thought they are yielding limited results. On Tuesday alone, the PBOC’s released a daily reference rate for the managed currency with the largest gap to expectations in nearly a month and it announced an extra bill sale in Hong Kong which should act as a support to the Chinese currency. 

Some state-owned Chinese banks were also seen selling dollars in the onshore market to help stabilize the yuan, according to two traders who weren’t authorized to talk about the foreign-exchange market publicly.

Still, the onshore yuan is trading at the largest discount to the official reference rate since December and it’s approaching the weak end of its trading band with the greenback. The currency is allowed to move 2% above and below the PBOC’s so-called fixing. 

“The dollar-yuan spot rate will likely test levels north of 7.3 in the coming sessions” and the 10-year yield may test 2.5% to 2.55% in weeks, said Becky Liu, head of China Macro strategy from Standard Chartered Plc. “The cut has been aggressive, indicating the urgency of stepping up measures to shore up credit growth.”

China Rate Cut Likely to Be Followed by More Steps, Analysts Say

China’s currency fell 0.3% to 7.2780 per dollar at lunchtime in Beijing. The 10-year yield stood at 2.57%, more than 160 basis points below its US equivalent, the widest gap since 2007.

To be sure, the PBOC has more tools in its arsenal if it wishes to curb drops in the yuan. It could strengthen its support via the daily fixing, which has been stronger than forecast since late June, and add dollar liquidity by allowing banks to hold less foreign-exchange in reserves. It already tweaked a rule to allow more inflows in July.

“The yuan could face more headwinds from China’s persistent run of weak data and further widened yield disadvantage,” said Jingyang Chen, Asia FX Strategist at HSBC. “The PBOC may continue to smooth volatility, but we do not expect it to draw a firm line in the sand when the tide keeps coming in.”

--With assistance from Chester Yung and Qizi Sun.

(Updates throughout)

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