Rate cut is imminent, can US bond yields continue to decline?

Abstract

(I) Rate cuts and rate cut trades: Rate cut trades precede rate cut cycles, and the "reversal" of trades needs to focus on the Fed's policy stance

Reviewing the 13 rate cut cycles of the Federal Reserve since the 1970s, the 10-year U.S. Treasury yield tends to decline. Before the rate cut lands, the slope of the U.S. Treasury yield decline is steeper, and after the rate cut lands, the slope of decline slows down. When the rate cut lands, factors such as the "rush" of rate cut trades and the increase in short positions may cause short-term rebounds in the U.S. Treasury yield, with the rebound in long-term U.S. Treasury yields potentially being greater.

After the rate cut lands, when will the 10-year U.S. Treasury yield reverse depends on when the Fed's policy shifts, and in previous rate cut cycles, the "reversal" of the 10-year U.S. Treasury yield often occurs around the last rate cut landing. It is worth emphasizing that this time, due to the significant rush of rate cut trades, attention should be paid to the "second derivative" of rate cuts, that is, the flattening of the rate cut slope.

(II) The pace of Fed rate cuts: The pace of Fed rate cuts depends on economic fundamentals, focusing on the elasticity of interest rate-sensitive sectors

The way the economy "lands" determines the slope and space of the U.S. Treasury yield decline. In a recession, the Fed cuts rates more aggressively; after 1982, the Fed began to shift towards using the federal funds rate as the main policy tool, and in the following 7 rate cut cycles, preventive rate cuts fell to near neutral rates, with rates potentially being "over-adjusted" in a recession.

The direction of inflation is the main contradiction in the Fed's policy stance shift. If the forces driving the rebound in inflation are temporary, then rate cut trades are more likely to be repeated rather than reversed. Generally, if the rebound in inflation is driven by the demand side, such as further tightening in the labor market in a tight state, then the sustainability of the inflation rebound may be higher.

(III) The space for Fed rate cuts: Assuming a core inflation center of 2.5% in 2025, the FFR center may be around 4%

Referring to the neutral rate framework, an FFR rate matching a 2.5% inflation is around 4%, which also means that the space for Fed rate cuts is about 100-150bp. Our baseline assumption for Fed rate cuts is 75bp+75bp. The first 75bp is for this year, and the second 75bp is after 2025. The outcome of the U.S. election may significantly impact the pace of the second 75bp.

In the short term, although there may be a rebound in long-term U.S. Treasury yields, the focus remains on exploring and grinding at the bottom, with the medium term still needing to pay attention to the "inflation stickiness - slowing rate cut pace - reversal of long-term rates" chain. By the end of 2025, short-term rates have priced in a 230bp rate cut, and the 10-year U.S. Treasury has priced in around 150bp. In the short term, there is a certain adjustment risk in the U.S. Treasury curve, but it may be mainly in the short term.

Main Report

As the Fed rate cut approaches, what is the downward space for U.S. Treasury yields? We believe that the pace of Fed rate cuts this year will be: 25bp+25bp+25bp. Rate cut trades have surged significantly, with short-term rebound risks in the near term, but the timing of the reversal still needs to be observed Hot Topic Analysis: Rate Cut Imminent, Can US Treasury Yields Continue to Decline?

(1) Rate Cut and Rate Cut Trading: Rate Cut Trading Precedes Rate Cuts, "Reversal" in Trading Requires Attention to Fed Policy Stance

During the Fed rate cut cycle, the 10-year US Treasury yield tends to decline. Before the first rate cut, the slope of the US Treasury yield decline is steeper, and after the rate cut, the slope slows down. Reviewing the 13 rate cut cycles by the Fed since the 1970s, 6 of them occurred in a soft landing environment, with an average of about 90 basis points cut 6 times; 7 times resulted in economic recession during or after rate cuts, with an average of about 633 basis points cut 15 times. Regardless of whether it is before the rate cut, after the rate cut, or during the rate cut cycle, the pace of interest rate changes may vary, but the 10-year US Treasury yield tends to decline.

After the first rate cut, the US Treasury yield may experience a short-term rebound. In the 3 months before the first rate cut, the 10-year US Treasury yield on average decreased by 62 basis points. Around 1 month after the first rate cut, due to trading-related factors, the US Treasury yield often rebounds, with an average rebound of about 11 basis points. The correlation between interest rate rebounds and economic recession is not significant. For example, in the cases of the soft landing in 1995 and the financial crisis in 2007, the US Treasury yield rebound may occur before and after the first rate cut, with a larger rebound in long-term interest rates.

After the rate cut, the timing of the US Treasury yield reversal depends on when the Fed policy shifts. In previous rate cut cycles, the reversal of the 10-year US Treasury yield often occurs around the last rate cut, indicating that the Fed policy direction plays a leading role. Taking the 2001 dot-com bubble crisis as an example, the stabilization point of the 10-year US Treasury yield was around the last rate cut in June 2003. In the preventive rate cut scenario in 1995, the timing of the 10-year US Treasury yield rebound was also around the last rate cut in January 1996.

Even if the economy stabilizes, it does not necessarily mean a Fed shift. The Fed's policy lag is evident in both rate hike cycles and rate cut cycles. The effectiveness of rate cuts has a lag time, and the length of the lag time itself is difficult to predict. Powell believed in 2022 that the effects of monetary policy often take 12-18 months to manifest. In the fourth quarter of 2001, the US GDP growth had bottomed out and rebounded, but it was not until mid-2003 that the Fed ended the rate cut cycle (2) The pace of Fed rate cuts: The pace of Fed rate cuts depends on economic fundamentals, focusing on the elasticity of interest rate-sensitive sectors

The way the economy "lands" determines the downward slope and space of US bond yields. In a recession, the Fed cuts rates more aggressively; in a soft landing scenario, the rate cuts are shallower. In a recession, the average Fed rate cut is 633 basis points, while in non-recession scenarios, the average cut is 90 basis points. In early 1995, the US economy began to slow down, and the market was concerned that the economy might enter a recession. To achieve a "soft landing," the Fed took relatively mild rate cuts in 1995 and 1996, totaling 75 basis points, reducing the rate from 6% to 5.25%.

If there is significant pressure from inflation rebound, it also constrains the depth of Fed rate cuts. Based on research on rate cut trades in the soft landing backgrounds of the 1960s and 1990s, it can be observed that inflation rebounds may correspond to repeated rate cut trades, and the sustainability of inflation rebounds determines whether rate cuts will be repeated or reversed. Furthermore, if the force driving the inflation rebound is temporary, then rate cut trades are more likely to be repeated rather than reversed. Generally, if the inflation rebound is driven by demand, such as further tightening in the labor market, the sustainability of the inflation rebound may be higher.

Anchoring on the neutral rate, considering both fundamentals and inflation factors, a slight rate cut may not ease the current level of monetary tightening. As of the third quarter of 2024, the actual effective federal funds rate in the US is around 2.4%, the actual natural rate is around 0.7%, exceeding 170 basis points, reaching the highest level of tightening in nearly 30 years. A slight rate cut may not ease the level of monetary tightening, posing risks of economic weakening. Since 1982, the Fed has shifted to using the federal funds rate as the main policy tool. In the seven rate cut cycles that followed, precautionary rate cuts have fallen to near the neutral rate, with deeper cuts in recession scenarios.

(3) The space for Fed rate cuts: Assuming a core inflation center of 2.5% in 2025, the FFR center may be around 4%

With rate cuts landing, trading factors may cause a short-term rebound in US bond yields. The current rate cut expectations are priced too aggressively, with the market expecting 125 basis points of cuts this year and another 125 basis points next year. The implied short-term "rate cut trades" in the futures market have exceeded the benchmark scenario given at the June FOMC meeting (FFR median at 5.1%, corresponding range of 5-5.25%, i.e., one rate cut). Considering the recent weakening data and the Fed's policy stance shift, the September meeting may further revise the rate cut curve through the Summary of Economic Projections We believe that the market has already priced in the interest rate cut excessively. Secondly, since August, the net short position of the 10-year US Treasury bond has been increasing. As the interest rate cut takes effect, short selling factors may lead to a short-term rebound in interest rates.

**In the medium term, US Treasury bond rates may still trend downwards. The focus of the Federal Reserve's policy stance has shifted from "fighting inflation" to "maximum employment." The upward risks of inflation have diminished, while the downward risks of employment have increased. In terms of inflation, unlike the "stagflation" period of the 1970s, during this inflation surge, the medium-term inflation expectations in the US are still anchored around 2.1% to 2.4%; in the medium term, US core service inflation is highly positively correlated with wage growth. The labor market is gradually loosening, and unless there are new exogenous shocks, the risk of inflation rebound may be "temporary" in the near future.

In terms of employment, the US labor market has basically completed the process of balancing, with further risks of "slackening." On one hand, the 4.3% unemployment rate is already higher than the natural rate of unemployment (4.1%); on the other hand, although the recent non-farm payroll additions are roughly equivalent to the pre-pandemic average (in the range of 150,000 to 200,000). The unemployment rate rose to 4.3% in July, and although there are some temporary factors, the trend of the unemployment rate in the near future still indicates that the phenomenon of slightly higher unemployment rate than the natural rate (4.2%) may not be temporary.

Referring to the neutral interest rate framework, the FFR rate matching a 2.5% inflation rate is around 4%, which also implies that the Fed has a rate cut space of about 100-150 basis points. Our baseline assumption for the Fed rate cut is 75bp+75bp. The first 75bp is for this year, and the second 75bp is after 2025. The outcome of the US presidential election may significantly impact the pace of the second 75bp.

In the short term, although long-term US Treasury bond rates may rebound, they are still mainly focused on exploring the bottom and grinding. In the medium term, attention still needs to be paid to the chain of "inflation stickiness - slowing rate cuts - reversal of long-term interest rates." By the end of 2025, short-term rates have priced in a 230bp rate cut, and the 10-year US Treasury bond has priced in around 150bp. In the short term, there is a certain adjustment risk in the US bond curve, but the short end may dominate.

Risk Warning:

Escalation of geopolitical conflicts; Federal Reserve turning "hawkish" again; Accelerated financial conditions tightening.