In a surprise move, China’s central bank on Tuesday lowered a short-term lending rate for the first time in 10 months, seeking to help restore market confidence and prop up a stalling post-pandemic recovery in the world's second-largest economy.

The cut to the lending rate signals possible easing for longer-term rates over the next week and beyond as demand and investor sentiment weaken, adding to the case for urgent policy stimulus to sustain growth.

The People's Bank of China (PBOC) cut its seven-day reverse repo rate by 10 basis points to 1.90% from 2.00% on Tuesday, when it injected 2 billion yuan ($279.97 million) through the short-term bond instrument.

Analysts had predicted monetary easing measures in the coming weeks, but in the form of a cut to the required reserve ratio – the amount of cash banks are required to hold – rather than a rate cut, Capital Economics economist Julian Evans-Pritchard said.

The cut reveals "growing concerns among policymakers about the health of China's recovery," Evans-Pritchard wrote in a note on Tuesday.

"The central bank's rate cut decision was not a complete surprise to the market," said Ken Cheung, chief Asian FX strategist at Mizuho Bank.

"Commercial banks have already lowered deposit rates, and PBOC governor Yi Gang also mentioned strengthening counter-cyclical adjustment recently."

The yuan hit a six-month low of 7.1680 per dollar after the rate decision while yields on China's benchmark 10-year government bonds fell to a fresh seven and a half month month low.

Cheung said the PBOC may have wanted to mitigate the impact of any future policy easing on the Chinese yuan ahead of the U.S. Federal Reserve's (Fed) policy meeting this week, which is keenly watched by financial markets.

China remains an outlier among global central banks as it loosens monetary policy to shore up growth while its major peers raise interest rates to counter surging consumer prices.

Further interest rate cuts in China would only widen the yield gap with the United States, even if the Fed pauses this week, sending the yuan lower and accelerating capital outflows.

China is due to release May credit lending data and activity indicators, including retail sales and industrial production, this week.

Tuesday's rate cut suggests policymakers are increasingly worried about the health of China's recovery, traders and analysts said.

"This reminds the market of the challenges that the Chinese economy faces during its recovery period," said Marco Sun, chief financial market analyst at MUFG Bank (China).

"However, the market is expecting the PBOC to cut the policy rate further. Looking ahead, the PBOC could make marginal adjustments to the policy rate in order to stimulate credit growth and avoid inflation issues in the coming quarters."

Dozen stimulus measures

Bloomberg reported on Tuesday, citing unnamed sources, that China was considering at least a dozen stimulus measures including cuts to interest rates to support areas such as real estate and domestic demand.

The next adjustment to rates could come as soon as Thursday, when the central bank is due to roll over 200 billion yuan ($27.93 billion) in medium-term lending facility (MLF) loans.

"The 10 bp cut in the open market operations (OMO) reverse repo rate can be seen as a precursor to an MLF rate cut this Thursday," said Frances Cheung, rates strategist at OCBC Bank.

"Rates may continue to trade on the soft side but given much economic pessimism and a rate cut are already in the price, we see limited downside to rates from here."

Separately, markets expect the benchmark lending loan prime rate (LPR), which is used to set consumer loan and mortgage rates, could be lowered by the same margin at the monthly fixing next Tuesday.

And some investment banks expect a 25 bp reduction to the reserve requirement ratio, or the amount of cash banks must set aside as reserves, this year.

"There could be less urgency to cut the RRR after these policy interest rate cuts... we now think the 25 bp RRR cut that we had previously forecast for June is likely to be delivered in Q3 instead," Goldman Sachs economists said in a note.

"There could be another RRR or policy interest rate cut in Q4, depending on the economic outcome over the next several months."