How will the "Fed rate cut expectations" affect the A-share market?

Report Summary

We discuss some key points of concern about the "rate cut trading" by the Federal Reserve, and its impact on A-share assets:

1. In the past half year, how has the U.S. stock market conducted inflation trading, rate cut trading, and recession trading?

2. At what stage is the current rate cut trading by the Federal Reserve?

3. How have various asset prices performed before and after rate cuts by the Federal Reserve?

4. How does the rate cut trading by the Federal Reserve transmit to A-share assets?

5. How does the U.S. bond interest rate affect the trend of the A-share growth sector?

How does the "rate cut trading" by the Federal Reserve affect the A-share market?

Recently, the U.S. Department of Labor released inflation data for June (CPI slowed to 3% year-on-year, down 0.1% month-on-month) and unemployment data for June (rising to 4.1%). The significant decline in inflation has raised market bets on a 90% rate cut by the Federal Reserve in September. At the same time, the unexpected rise in the unemployment rate has led to more discussions on the "Sam Rule" 0.5% critical value pointing to a recession signal. In this situation, the market's reaction is complex: on one hand, the U.S. stock market has shown high and low cuts, initiating "rate cut trading," with rate-sensitive assets such as the Russell 2000, real estate, and biotech rebounding significantly; on the other hand, copper prices have plummeted, high valuation assets have fallen sharply, seemingly also engaging in "recession trading," but with the Producer Price Index (PPI) exceeding expectations the next day, the "recession trading" has weakened. This week, we will discuss some key points of concern about the "rate cut trading" by the Federal Reserve and its impact on A-share assets.

(1) In the past half year, how has the U.S. stock market conducted inflation trading, rate cut trading, and recession trading?

Since the fourth quarter of last year, the U.S. inflation trading, rate cut trading, and recession trading have been in a "back and forth" pattern. In the fourth quarter of last year, the Federal Reserve's "rate cut trading" gained momentum, mainly driven by easing pressures on U.S. employment, Treasury debt issuance impacts, energy prices, and weakening economic data in November, leading to discussions on rate cuts at the December FOMC meeting. By the end of the year, the market had priced in the highest expectations for 24 rate cuts throughout the year. However, since the beginning of this year, with economic data and inflation exceeding expectations, coupled with the January FOMC meeting indicating no rate cut in March, the market shifted towards "inflation trading." Subsequent evidence of recovery and inflation continued to strengthen, leading to downward revisions in rate cut expectations, with the expected 24 rate cuts for the year reduced to only 1 by April-May. After the recent release of inflation and unemployment data for June, market trading sentiment has once again shifted towards "rate cut trading."

(2) At what stage is the current rate cut trading by the Federal Reserve?

On July 10th, Powell stated at a hearing that the "Federal Reserve does not need to wait for inflation to drop to 2% before starting rate cuts." The further cooling of inflation in the June data released the next day seems to provide the best response, bringing the Federal Reserve's rate cut closer to the "threshold." According to the CME FedWatch Tool, the current market is pricing in a rate cut by the Federal Reserve in September and a total of 3 rate cuts for the year.

In fact, based on the macroeconomic conditions surrounding past initial rate cuts by the Federal Reserve (since the 1990s), on average: the month of the initial rate cut saw a year-on-year CPI of 2.5%, PPI of 2.6%, an unemployment rate of 4.6%, and a PMI of 48.4. The current inflation level is gradually approaching the "trigger condition", but the unemployment rate and PMI (especially Markit PMI) are still significantly better than historical averages. Therefore, Powell also emphasized that "interest rates are unlikely to fall to the extremely low levels before the crisis".

(III) How do asset prices perform before and after past rate cuts by the Federal Reserve?

Historically, there are several scenarios for Federal Reserve rate cuts: first, cutting rates to combat economic downturns (1973-1974, 1980, 1981, 1989, 2001, 2007); second, cutting rates in response to global risks or market crashes (1987, 1998, 2020); third, preemptive rate cuts in a relatively stable macro environment (1989, 1995, 2019).

In the first scenario, if the Federal Reserve cuts rates to combat a downturn, both macro fundamentals and asset prices are generally weak; in the second scenario, if the Federal Reserve cuts rates to address risks, macro fundamentals and asset prices may rebound quickly after a brief shock; in the third scenario, if the Federal Reserve cuts rates preemptively, there may be a soft landing followed by a recovery, with equity assets generally performing well and commodities possibly falling before rising.

Specifically, the performance of asset prices after the initial rate cut by the Federal Reserve:

(1) 10-Year Treasury Yield: After the initial rate cut, the 10-year Treasury yield mostly continued to fluctuate downward, but the rate of decline slowed compared to before the cut. On average: a 3.5% decline over 60 trading days, and an average 4% decline over 120 trading days. In preemptive rate cut scenarios (1995, 2019), the medium-term Treasury yields also decreased, with magnitudes similar to historical averages.

(2) Copper Price: After the initial rate cut, the copper price continued to fluctuate, with prices mostly experiencing a slight decline. On average after past initial rate cuts: no change in price over 60 trading days, and an average 2% decline over 120 trading days. Commodity prices generally first price in economic uncertainty before pricing in economic recovery, so commodity prices usually fall before rising, with the extent and duration of the decline depending on whether the economy experiences a soft or hard landing （3）Oil Price: After the first interest rate cut, the oil price continued to fluctuate, showing a mostly downward trend followed by an upward trend in the medium term. On average, after the first interest rate cut, the price dropped by 5% over 60 trading days and increased by 6% over 120 trading days.

（4）Gold: After the first interest rate cut, the gold price showed a strong fluctuation with a slight upward trend. On average, after the first interest rate cut, the price dropped by 0.7% over 60 trading days and increased by 7.2% over 120 trading days.

(IV) How Does the Fed's Interest Rate Cut Transmission Affect A-share Assets?

The Fed's interest rate cut transmission may have two transmission paths:

One is on the denominator side. With the expectation of global liquidity easing and improved risk appetite, low-priced stagnant varieties or interest rate-sensitive assets are repaired, such as US small caps, real estate, biotech, as well as Chinese concept stocks, and Hang Seng technology stocks.

However, this level is only the logic of valuation repair, which is relatively difficult to determine the trend of asset prices, especially since the current interest rate cut space should not be too optimistic. Ultimately, it still needs to return to the judgment of the fundamentals. The direct impact on A-share denominator is relatively limited, and more may come from indirect effects: Fed interest rate cut → Renminbi exchange rate pressure relief → Monetary policy space opens up, with expectations of further easing.

For example, from November 23 to January 24, the US bond yields continued to decline by more than 100 bps, which helped improve the risk appetite of global equity assets. However, at the same time, the weakening profit expectations of A-share assets (PMI below 50 and further decline) have become the core factor in pricing A-share assets, making it difficult for the market performance to improve.

The other is on the numerator side. Looking at the past performance of asset prices before and after interest rate cuts, it may be necessary to first trade macro uncertainties (soft landing or hard landing) in sequence, and then trade recovery (real estate, consumer demand boosted). If economic data resilience is good, direct trading recovery is not ruled out For A-shares, the core resilience to the recovery of external demand is transmitted through the following chain:

(1) The global interest rate cut cycle begins → North American real estate cycle accelerates recovery → North American durable goods demand warms up → China's new export orders pick up

(2) The global interest rate cut cycle begins → Global manufacturing PMI rebounds → Global pricing of commodities (such as copper) demand warms up → Commodity profits rise

(V) How does the US Treasury bond yield affect the trend of the growth sector of A-shares?

For A-share assets, the US Treasury bond yield can be "icing on the cake", rather than "a timely help".

Taking the new energy industry as an example: ① In 2020-2021, as new energy profits rise and US Treasury bond yields rise, the fundamentals are priced in, and the US Treasury bond yield is not sensitive; ② In the first three quarters of 2022-2023, as new energy profits decline and US Treasury bond yields rise, the market shows a situation of both profit and valuation decline; ③ In the fourth quarter of 2023 to 2024, as new energy profits decline and US Treasury bond yields rise, it is still based on fundamentals pricing, and the US Treasury bond yield is not sensitive. There is a period of "icing on the cake" in the second and third quarters of 2021 when rising new energy profits meet a phase of decline in US Treasury bond yields.

In summary, in the second half of the year during the Fed's interest rate cut process, it is recommended to pay attention to sectors with relatively low valuations and marginal changes in fundamentals that can be "icing on the cake", including but not limited to: semiconductors, innovative drugs, and military industries.

Unless otherwise specified in this chapter, the data source is Wind data.

Risk Warning

Geopolitical conflicts exceed expectations, Fed easing falls short of expectations, domestic economic growth falls short of expectations (difficulties in the recovery of real estate and consumer confidence), etc.

Liu Chenming: SAC License No.: S0260524020001 Zheng Kai: SAC License No.: S0260515090004 Li Rujuan: SAC License No.: S0260524030002