(Bloomberg) -- China’s government bonds extended a rally and bank shares advanced, after the nation asked commercial lenders to cap some deposit rates in a push to support a bumpy economic recovery. 

The yield on 10-year notes dipped two basis points on Thursday to its lowest since November and a gauge of Chinese financial stocks jumped as much as 1.5%. The country’s biggest state-owned banks were permitted to lower the rates on so-called agreement and call deposits, according to a notice seen by Bloomberg News. The move will help drive down their costs, giving them scope to lower loan rates and helping to fuel lending in the economy.

The news, which follows similar moves in early May and last year, alleviates pressures on lenders as they strive to balance shrinking margins and government directives to beef up lending support to the economy. 

China’s sovereign bonds have been enjoying a stellar run since March, as investors grow skeptical over the reopening trade and start to position for further easing. Data Thursday showing slower growth in inflation also boosted the case for more stimulus. 

The news “could be a signal that the People’s Bank of China is validating the recent move lower in money market rates,” Nomura Holdings Inc. economists led by Lu Ting wrote in a note. “However, following the recent strong rally, we expect China rates to consolidate around current levels.”

Four biggest state-owned banks, including Industrial & Commercial Bank of China Ltd., can offer up to 10 basis points above the benchmark rates on agreement and call deposits, while other lenders are told to cap the ceiling at 20 basis points, the notice said. The change would imply a drop of 40 to 55 basis points from previous ceilings, according to Guotai Junan Securities Co. 

The shift, which takes effect from next Monday, was communicated through the nation’s interest rate self-disciplinary mechanism overseen by the central bank. Reuters reported on the move earlier.

Patchy Recovery

Recent data suggest the economy’s recovery is increasingly patchy, clouding the outlook for growth after a better-than-expected expansion in the first quarter. Chinese banks made 718 billion yuan ($103 billion) of new loans in April, about half of the average estimate in a Bloomberg survey, according to official data released Thursday. 

Consumer inflation slowed to the weakest pace in two years in April while producer prices fell further into deflation. The China Caixin manufacturing purchasing managers index dropped to 49.5 last month from 50 in March, pointing to a contraction in factory output for the first time since January.

The rates market is pricing in looser conditions going forward — a gauge of traders bets for future interbank rates has fallen to the lowest since January and bank borrowing costs for short-term debt have declined. 

Some bond bears have turned tail. Strategists at Citigroup Inc. on Thursday neutralized their underweight view on China debt in their emerging market bond portfolio, as lower funding costs for banks after the deposit rate cuts will spur demand for bonds, they said.

Investors are now focusing on the central bank’s medium-term liquidity operations on Monday to get a hint of Beijing’s policy stance. 

Limited Impact

China’s commercial lenders have had some leeway in setting their own rates since the central bank scrapped direct control in 2005. The PBOC, however, maintains substantial sway by setting a ceiling and floor for rates through the interest rate self-disciplinary body.

The latest adjustment will effectively lower rates on agreement and call deposits at medium and small banks, China Merchants Securities Co. analyst Liao Zhiming wrote in a Thursday report, adding the impact will be relatively limited on big lenders. The highest rate for agreement deposits would be 1.25% for big four banks and 1.35% for other lenders after the move, according to the note. 

Guotai Junan said the overall impact is likely to be limited as most lenders’ current rate offerings remain below the new caps. 

Chinese banks are under pressure to maintain profitability as their earnings are weighed down by falling rates and a government push to provide cheap loans to small businesses and home buyers.

--With assistance from Wenjin Lv.

(Updates 8th paragraph with the latest credit data.)

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