Trading a Chinese Rate Cut

As Chinese growth slows, traders are beginning to ponder if and how China will try to reflate its economy. A greater than expected slowdown in China pushed policymakers to cut lending and deposit rates on June 7. Similar cuts had not occurred since the onset of the financial crisis.

In 2008-2009, China embarked on an enormous fiscal stimulus plan, which invested in infrastructure and created uninhabited "ghost cities." Friday, analysts are expecting the government to rely on rate cuts, rather than fiscal stimulus, to spur growth. The 4 trillion yuan ($628 billion) package launched in 2008-2009 did super charge growth, but also left local governments saddled with debt that later started to sour.

Analysts are expecting future rate cuts to come in the form of continued benchmark rate cuts for lending and deposit rates and Reserve Requirement Ratio (RRR) cuts. By cutting the RRR, China lowers the amount of capital the country's banks must hold. The goal of this RRR cut is to encourage banks to lend their excess reserves, thus stimulating growth. JP Morgan is expecting another 25 basis point cut in the benchmark rates, as well as two cuts of the RRR by 25 basis points each.

Traders who expect further China cuts would be smart to go long (buy) commodities such as copper and oil, as cuts generally signal pro-growth policies. Following China rate cuts, copper and Aussie dollar would likely rally in tandem. Investors looking to capitalize on this would thus be wise to long copper and long the AUD/USD.

The downside to cutting rates is the same reason China raised them in the first place: inflation. China, specifically its major cities such as Beijing, has been experiencing a property bubble. Rate cuts would likely exacerbate this issue. Also, rate cuts may have been the cause of China's round of inflation following the financial crisis. During this inflationary period, food prices climbed at a 10% annualized rate. Thus, China's policymakers might consider some downsides to monetary easing via rate cuts.