The U.S. interest rate cut cycle has begun, are you ready?

At the Jackson Hole meeting on August 24th, Federal Reserve Chairman Powell stated that "the time has come for policy to adjust," but "the timing and pace of rate cuts will depend on upcoming data, changing outlooks, and risk balances." With this, various speculations about the timing of rate cuts in the market have settled, and the first rate cut date has been set for September 18th this year. The rate cut cycle is about to begin, but there is still significant uncertainty regarding the pace and magnitude of the cuts.

Blind Men Feeling the Elephant Compared with the Rate Cuts in 2019

The last time the Federal Reserve began a rate cut cycle was on July 31, 2019 (25bp cut), followed by two more cuts of 25bp each in September and October, totaling 75bp in the second half of 2019. Market expectations now suggest that there will be rate cuts in the September, November, and December meetings this year, totaling 4 cuts (100bp) within the year, which seems similar to the situation in 2019.

From the data, although the labor market has cooled down, the average monthly job additions in May, June, and July reached 197,000 (considering only the initial values), higher than the 154,000 in 2019. However, the unemployment rate is significantly higher than in 2019, with a trend of further increase. Looking at inflation data, the month-on-month data is similar to 2019, but the year-on-year data is higher. In terms of economic prosperity index, the current PMI data is significantly lower than the same period in 2019.

Powell stated in his speech, "Inflation has declined significantly compared to the pandemic period, the labor market is no longer overheated, and supply constraints are normalizing." The data above also confirms this, indicating that the Fed will start cutting rates in September.

Has the Rate Cut Expectation Passed?

According to the pricing in the interest rate futures market, the current market expects the Fed to cut rates 4 times this year, totaling 100bp, with approximately 33bp expected cuts in September, November, and December each. There is an expectation of a total 200bp rate cut in the next year, meaning another 100bp cut in the first three quarters of next year.

Figure 1: Market expectations for Fed rate cuts

Given the current rate cut expectations, two questions come to mind:

Question 1: Is a 50bp rate cut possible in September this year?

Looking back at the past 6 rate cut cycles, the initial rate cut magnitude varied: two were 50bp, three were 25bp, and one was 13bp. A 25bp cut is the norm, with a 50bp cut only occurring in times of economic crisis and significant stock market declines

Currently, the labor market in the United States is cooling down, inflation is falling, but there is far from an economic recession or crisis. A survey of investment managers at U.S. banks in August showed that 87% of investors believe there is a high probability of a soft landing or no landing for the economy. Although there have been pullbacks in the U.S. stock market, the overall performance remains strong. As of the end of August, the Dow Jones Industrial Average, the Nasdaq Composite, and the S&P 500 Index have risen by 10.28%, 18%, and 18.42% respectively this year. Therefore, we believe that the first interest rate cut in September this year is likely to be 25 basis points.

Question 2: Will there be a total rate cut of 200 basis points in the next year?

In the recent three rate-cutting cycles, there have been instances where the total rate cut exceeded 200 basis points within a year after the first rate cut. Upon closer observation, it can be seen that a significant rate cut in a short period of time occurs under the following conditions: 1. Economic recession occurs; 2. U.S. stocks experience a major decline; 3. A black swan event occurs (such as the "9/11" incident in 2001, the collapse of Lehman Brothers in 2008, and the COVID-19 pandemic in 2020). Furthermore, the black swan event usually happens a few months after the rate-cutting cycle begins, accelerating the pace of rate cuts.

Chart 2: Situations of past rate-cutting cycles

The current rate cut by the Federal Reserve is a precautionary measure, not an emergency response to a crisis, similar to the situations in 1995 and 2019. In 1995, after the rate-cutting cycle began, a total of 3 rate cuts amounting to 75 basis points ended the cycle. In 2019, there were also 3 rate cuts totaling 75 basis points. However, in March 2020, the COVID-19 pandemic led to an emergency rate cut of 150 basis points by the Federal Reserve.

So, is the current rate-cutting situation more like 1995 or 2019? In fact, it could be either, depending on whether a crisis erupts in the future. As Federal Reserve Chairman Powell mentioned, future monetary policy adjustments will depend on published data, changing prospects, and risk balance. We expect that the Federal Reserve will cut rates 3 times this year (25 basis points each time) and another 2 to 3 times in the first half of next year. However, unexpected events can always occur in the market. If a black swan event triggers an economic recession in the United States, given the current high interest rates, there is significant room for rate cuts.

Market expectations for rate cuts will continue to adjust, and U.S. bond yields will not decline continuously. Significant fluctuations back and forth are the norm.

Author: Zhang Xiaobo, Source: Morning Market, Original Title: "The Beginning of the Rate-Cutting Cycle, Are You Ready?"