Federal Reserve: How to play the next move after the first interest rate cut?

The 50bp rate cut by the Federal Reserve in September is indeed unusual. Despite meeting the market's expectations and initiating this round of rate cuts with a 50bp magnitude, there are at least three "unusual aspects" that are worth pondering:

First, there was a rare "accident" in policy communication. The usually transparent Federal Reserve did not convey the possibility of a 50bp rate cut in its official statements before the blackout period of this meeting. Even the usually well-informed WSJ hesitated in its views, and there was also a rare dissenting vote on interest rate decisions internally (the first time since 2005).

Second, the 50bp rate cut is actually a "compensatory" 25bp. It is quite strange to cut rates by 50bp for the first time when there is little risk of a recession. From the content of the meeting, it is essentially a 25bp cut in September, compensating for the 25bp cut in July.

Third, in order to have it both ways, the rate cut path is somewhat "deformed" but still very conservative. From the communication perspective, the Federal Reserve is in a dilemma of not wanting to lag behind the curve while also not wanting to signal recession risks. Therefore, the rate cut process after September remains cautious: another 50bp cut this year (25bp each in November and December), followed by a 100bp cut next year (25bp each quarter, or continuous cuts until the end of June).

A rare compensatory rate cut, with a "loosening first and tightening later" rate path. The unexpected September rate decision meeting, especially the compensatory meaning behind the 50bp cut, shows that under Powell's leadership, the Federal Reserve is trying to change the past "slow pivot" issue. However, this has made the future rate path appear somewhat peculiar and has also introduced uncertainty. We believe the following 4 points are worth noting about the meeting:

Not cutting rates in July was a "mistake". During the press conference, Federal Reserve Chairman Powell clearly stated that if they had received the July non-farm payroll report before the July meeting (released in early August), they would likely have cut rates at that time.

Rate cuts in November and December will return to 25bp. There have been significant changes in the dot plot released in September, with the median level for 2024 lowered to between 4.25% and 4.5%, indicating a 100bp cut within the year. Therefore, the high probability is that the pace of rate cuts in November and December will return to 25bp.

The pace of rate cuts in 2025 may further slow down. The median level in the 2025 dot plot has been adjusted to between 3.25% and 3.5%, implying a further 100bp cut next year: possibly 25bp cuts each quarter, or pausing rate cuts after four consecutive cuts in the first half of the year. Considering that the subsequent recession risks are manageable and there may be a need to focus on the risk of inflation rebound, we tend to believe that the former scenario is more likely to occur Employment remains the "focus" of the current rate cut, while the risk of inflation is temporarily overlooked. The minutes of the September Fed meeting emphasized more on the cooling of the job market, supporting maximizing employment as a priority goal (support maximum employment ahead of the inflation target). Although inflation is not low, the Fed is confident in further falling towards the 2% target, balancing the risks of inflation and employment.

After the first rate cut, market expectations for further rate cuts tend to intensify. Historically, after the first rate cut, market predictions for the rate cut path are not more accurate, but rather tend to increase the deviation between market expectations and actual conditions: regardless of whether the U.S. economy eventually experiences a soft landing or a recession, after the first rate cut, market expectations for the magnitude of future rate cuts are likely to increase. This situation has occurred in 4 out of the past 5 rate cut cycles.

How long does it take to confirm a soft landing after the first rate cut? At least one quarter. In the 1-3 months after the first rate cut, employment data remains the focus. The market evaluates the path of future rate cuts based on the strength of employment data, but the data fluctuates significantly in the first 1-3 months, leading to inaccurate assessments of the rate cut path by the market.

It is only after 3 months following the first rate cut that the market will have a complete assessment of the employment situation, which will determine whether it is a "soft landing" or a "recession," and the subsequent monetary policy path will become clearer: the impact of non-farm payroll data on asset prices will significantly decrease, CPI data will once again become the market's pricing focus; at the same time, the differentiation in U.S. stocks between recession and non-recession scenarios will become significant.

Author: Shao Xiang (S0600523010001), Wu Bin; Source: Chuan Yue Global Macro; Original Title: "Fed: How to Play the Next Move After the First Rate Cut?"