Interest rate futures > Gold > Copper > US Treasury Bonds > US Stocks

Since July, various assets have shown a "roller-coaster" market, with the underlying factor being the fluctuation in expectations for a rate cut by the Federal Reserve. From the dilemma of whether the Fed can start cutting rates in September, concerns about a slight rate cut and the potential inflation pressure from Trump's trade deals, keeping US bonds fluctuating in the range of 4.3%-4.5%; to the shift to rate cut trades after a significant cooling in June inflation data, with gold rising to nearly $2500 per ounce; and then to concerns about weakening manufacturing PMI and non-farm payrolls in July triggering recession fears, even expecting the Fed to urgently start a substantial rate cut, leading to a rapid decline in US bonds, the US dollar to 3.7% and 102, and a significant pullback in US stocks.

Recently, the strength in service PMI and retail data has led the market back to the expectation of a slight rate cut by the Federal Reserve under the "soft landing" scenario. After the market's expected "reversal run," how should the policy path be judged? How much expectation has been factored into various assets, whether it is excessive or still has room for growth? In this article, we will analyze this quantitatively.

Abstract

Federal Reserve's Policy Path? Likely to start in September, but the overall rate cut under the "soft landing" scenario is limited

The expectation of a significant and urgent rate cut due to recession fears is not realistic. Before the September FOMC meeting, August inflation, non-farm data, and this week's Jackson Hole meeting may further confirm the policy path.

How much rate cut expectation has been factored into various assets? Ranking of "front-running" degree, interest rate futures > gold > copper > US bonds > US stocks

Interest rate futures imply the most rate cuts in the next year (7 times), followed by gold (2.6 times), with copper (2.4 times) and short-term bonds (2.3 times) close behind, and US stocks (0.8 times) factoring in the least rate cut expectations. In other words, if the rate cut path is lower than expected, US stocks will not be under significant pressure, and profit prospects will be more important.

How will asset trends evolve? US bonds and gold "trading ranges" before rate cuts, gradually shifting to pro-cyclical assets after rate cuts

Before the rate cut, denominator assets such as US bonds and gold can continue to be held, but due to the expectation of front-running and the limited overall space for rate cuts, it is more of a "trading range." After the rate cut, as the fundamentals gradually stabilize and recover, a switch to pro-cyclical assets and sectors can be made.

Main Text

I. Federal Reserve's Policy Path? Likely to start in September, but the overall rate cut under the "soft landing" scenario is limited

It is highly likely that a rate cut will be initiated in September, which the market has already fully priced in. From the perspective of the Fed's policy objectives and recent statements by officials, a rate cut in September is already a "high probability": on one hand, inflation is falling towards the 2% target, and the labor market is also cooling. Overall and core CPI in July continued to fall year-on-year, the unemployment rate rose to 4.3%, and non-farm payroll additions were lower than expected, all paving the way for a rate cut by the Fed in September; on the other hand, Fed officials have recently made dovish remarks, heating up expectations for a rate cut. In particular, Powell has emphasized in multiple speeches, including at the Washington Economic Club interview, that there is no need to wait for inflation to fall to 2% before cutting rates [1], expressing concerns that delaying the rate cut could put pressure on the economy. Recent market turmoil will also increase the Fed's pressure to avoid delaying the rate cut Regarding September as the first rate cut point, the market is also not divided. The current CME rate expectation implies a 100% probability of a rate cut in September, with only differences in magnitude. The probability of a 25bp rate cut is higher at 75%, consistent with Powell's denial of the possibility of a 50bp rate cut after the July FOMC meeting.

Chart: Powell's recent major statements and speeches are generally dovish.

Source: Bloomberg, CICC Research Department

However, under the baseline scenario, the overall rate cut this round may be limited (4-5 times, around 100bp). The expectation of a significant and urgent rate cut based on recession concerns is not realistic. We have reviewed the synchronous and leading indicators of the U.S. economic fundamentals, examined the current pressure triggering a recession, and judged that the U.S. economy is in a downward trend, with corporate income growth gradually slowing down. However, due to the different "seesaws" between various sectors that can offset each other, there is no overall deceleration pressure on the economy ("Criteria and Historical Experience for Recession Judgment"). At the same time, the gap between private sector financing costs and investment returns is not significant, and the monetary tightening's suppression of demand is marginal. Therefore, a certain degree of rate cut can reinvigorate demand. For example, at the beginning of the year, the market traded loosely, with long-term bond rates falling to 3.8%, driving overall financial conditions to ease. The year-on-year growth rate of residential mortgage loans and the scale of corporate bond issuance hit new highs since 2022 ("Rate Cut Trading Manual") In this scenario, we estimate that cutting interest rates by 4-5 times (around 100 basis points) can alleviate the restrictiveness of monetary policy, and demand and growth may return to an upward trajectory, corresponding to a central 10-year U.S. Treasury bond rate of 4% ("New Thinking on Calculating U.S. Treasury Rates"). In addition, inflation is tailing off in the fourth quarter, and after the rate cut, with improved demand, price pressures may rise again, and the inflationary nature of policies from both parties may also constrain the extent of this round of rate cuts ("Global Market Outlook for the Second Half of 2024: Easing is Halfway Through").

Chart: U.S. residential mortgage rates have fallen below rental yields for 30 years

Source: Haver, CICC Research Department

Chart: U.S. corporate financing costs (6.6%) are slightly higher than investment returns (5.9%)

Source: Haver, CICC Research Department

Chart: We expect various aspects of the US economy in the second half of the year to show a "one down, two up" trend, leading to a "soft landing" after the rate cut.

Source: CICC Research Department

Before the September FOMC meeting, key data and this week's Jackson Hole meeting may further confirm the policy path. Prior to the September FOMC meeting (September 16-17), other factors influencing the policy path include the Jackson Hole Global Central Bank Annual Meeting (Powell's speech on Friday, August 23), August non-farm payrolls (September 6), and CPI (September 11). Our preliminary estimate shows that both overall and core CPI will continue to decline, with overall CPI expected to drop from 2.9% in July to 2.6% in August, and core CPI expected to decrease from 3.2% in July to 3.1% in August. This aligns with Powell's statement that "inflation continues to fall, and the job market remains stable," which will have limited impact on the path to rate cuts in September.

Chart: Overall and core CPI are expected to continue to decline in the third quarter; a slight uptick may occur in the fourth quarter.

Source: Haver, Bloomberg, CICC Research Department

At this week's Jackson Hole meeting, Powell may reiterate the downward trend in inflation and the balance between the employment target, signaling a moderate rate cut. The Jackson Hole Global Central Bank Annual Meeting brings together central bank governors, finance ministers, heads of international organizations, and economists from around the world to discuss the most critical global economic and monetary policy issues. The speech by the Fed Chair is particularly anticipated. This year's theme is "Reassessing the Effectiveness and Transmission of Monetary Policy," serving as a prelude to the Fed's current rate cut cycle. We expect Powell to continue his moderate "dovish" stance, emphasizing that "Fed rate cuts do not necessarily require inflation to fall to 2%, but only need a trend towards 2%," while conveying the Fed's balance between inflation and employment goals Chart: Fed Dot Plot Expects One Rate Cut This Year and Four Next Year

Source: Federal Reserve, CICC Research Department

II. How much rate cut expectation is priced in various assets? Ranking of "front-running" degree: interest rate futures > gold > copper > US Treasury bonds > US stocks

Despite the Fed's hint of a rate cut in September in the July FOMC statement, after experiencing weak job and data figures in July, the market clearly expects the Fed to "act earlier and more aggressively". With the boost of the escalating "recession narrative", US Treasury bonds and the US dollar significantly weakened, and US stocks also saw a noticeable pullback. However, in the past two weeks, some data including service PMI and retail sales have shown resilience in the economy. Major assets have shifted from extreme recession concerns back to a more balanced state, with US Treasury bond yields rebounding from a low of 3.7% to 3.9% and US stocks recovering most of their previous losses. Compared to the possible paths discussed earlier, how much expectation is currently priced into various assets? Is it already excessive or is there still room for adjustment? Referring to the methodology in "Model Deduction of Rate Hike Expectations for Various Assets", we calculated as follows:

Chart: We calculated the future 1-year rate cut expectations priced into interest rate futures, gold, and US stocks at 175bp, 65bp, and 21bp respectively

Note: Data as of August 16, 2024

Source: Bloomberg, Federal Reserve, CICC Research Department ► Interest Rate Futures: Implied 7 rate cuts in the future over the next year. The current implied interest rate level for August 2025 in the interest rate futures market is 3.8%, indicating a need for 7 rate cuts from the current Federal Reserve Fund rate level over the next year. The specific path implied by CME interest rate futures is to raise rates by 25bp in September, cut rates by 25bp each in November and December, cut rates by 50bp in January 2025, and cut rates by 25bp each in March and June.

Chart: CME interest rate futures imply a 25bp rate cut in September

Source: CME, CICC Research Department

► Gold: Implied 2.6 rate cuts in the future over the next year, second only to CME interest rate futures. Based on the relationship between actual interest rates, the US dollar, and gold, we calculate that the current gold price (~$2508 per ounce) implies an actual interest rate of 1.76%, slightly lower than the current actual rate of 1.80%. Following more interest rate futures, gold incorporates more rate cut expectations, corresponding to a 64.7bp rate cut over the next year.

Chart: Based on the relationship between actual interest rates and gold, we calculate that the current gold price (~$2508 per ounce) implies an actual interest rate of ~1.76%

Source: Bloomberg, CICC Research Department

► Copper: Implied 2.4 rate cuts in the future over the next year, lower than CME interest rate futures and gold. Based on inflation expectations and the relationship between the US dollar and copper prices, we calculate that the current copper price (~$415 per ton) implies an inflation expectation of 2.10%, slightly higher than the current actual level of 2.08%, corresponding to a 58.8bp rate cut over the next year.

► US Treasuries: Short-term US Treasuries imply 2.3 rate cuts in the future over the next year, while long-term US Treasuries are below our calculated central level of 4%, indicating more comprehensive expectations for short-term bonds. The 1-year US Treasury currently implies a 56.7bp rate cut over the next year, down 10bp from the rise during heightened recession concerns, reducing the necessity for a significant emergency rate cut by the Federal Reserve. Long-term US Treasuries quickly broke through the 3.7% level amid weakening non-farm data and the "recession narrative" sentiment supported by global equity market volatility at the beginning of last week, but resilient economic data in the past two weeks have pushed long bonds back up to around 3.9% However, it is still slightly below the 4% central tendency we calculated ("A New Approach to Calculating US Treasury Yields"), indicating that the rate cut expectations factored into long-term bonds are also relatively sufficient.

Chart: Based on the relationship between valuation, credit spreads, and interest rates, we calculate that the current dynamic valuation of US stocks implies a 10-year US Treasury yield of 4.45%.

Source: Bloomberg, CICC Research Department

► US Stocks: Implied rate cut of 0.8 times in the next year, the asset with the least rate cut expectations among various asset classes. Based on the relationship between US Treasury yields, credit spreads, and the dynamic valuation of US stocks, we calculate that the current dynamic valuation of the S&P 500 Index at 21.2 times implies a 10-year US Treasury yield of 4.45%, corresponding to a rate cut of 20.6 basis points in the next year, which is the least among various asset classes. In other words, if the rate cut path is lower than expected, US stocks will not face significant pressure solely due to this, and profit prospects are more important.

III. How will asset trends evolve in the future? "Swing trading" US Treasuries and gold before rate cuts, gradually shifting to pro-cyclical assets after rate cuts

Based on the trend of falling inflation and official statements from the Federal Reserve, we believe that the policy path is relatively certain, with rate cuts expected to begin in September, but with limited overall magnitude. Since various assets have already factored in a certain degree of rate cut expectations, before the rate cuts, denominator assets such as US Treasuries and gold can continue to be held, but due to expectations running ahead and the limited overall space for rate cuts, it is more about "swing trading" and not recommended to increase positions, adopting a "wait and see" approach. After the rate cuts, as the fundamentals gradually stabilize and improve, a gradual shift to pro-cyclical assets and sectors can be made. Specifically:

► Before the rate cuts are realized, US Treasuries and gold, which benefit from loose trading conditions, may relatively benefit, but with limited room, they are more suitable for "swing trading" before the rate cuts. 1) We calculate that the central tendency of this rate cut cycle for long-term bonds is around 4%, and the rate cut realization may push it down to a low of 3.8%, so the current position of 3.9% has limited downward potential; 2) Compared to US Treasuries, combining actual interest rates (1-1.5%) and the fundamental model of the US dollar (102-106) (without considering other geopolitical situations and risk factors), we calculate that the reasonable central tendency for gold is $2500 per ounce Chart: US Treasury bond center around 4%; sell-off after rate cut (3.7%), timely exit after rate cut

Source: Bloomberg, CICC Research Department

Chart: Calculated based on an annual real interest rate of 1-1.5% and a USD 102-106 range, the center price of gold may be around USD 2500 per ounce

Source: Bloomberg, CICC Research Department

► After the rate cut is realized, gradually shift from assets benefiting only from the denominator end to assets benefiting from profit recovery at the numerator end, such as US stocks and copper. Before the rate cut, under the amplification of emotions, weakening economic data or risk events will bring significant pullback pressure to risk assets such as US stocks and copper. However, we are not pessimistic about risk assets. Combining our judgment on this round of rate cuts and fundamental repair path, the pullback actually provides better entry opportunities. We can wait for demand recovery after the rate cut and expectations of policy stimulus after the election (Basis for Recession Judgment and Historical Experience).

Chart: This round of rate cuts is similar to the mild rate cut soft landing in 2019, with US Treasury bonds and gold dominating before the rate cut, and then switching to US stocks and copper

Source: Bloomberg, CICC Research Department

Before the September FOMC meeting, we have summarized the economic data and events that the market may focus on, including: Democratic National Convention (August 19th - August 21st), August Markit PMI data (August 22nd), Jackson Hole Conference Powell speech (August 23rd), August ISM Manufacturing PMI (September 3rd), August ISM Services PMI (September 5th), August unemployment rate and non-farm payrolls (September 6th), August CPI (September 11th).

[1] https://wallstreetcn.com/articles/3719280

Authors: Liu Gang S0080512030003, Wang Zilin S0080123090053, Source: CICC Insight, Original Title: "CICC: How much are various assets pricing in rate cut expectations?"