CICC: Federal Reserve's "Unconventional" Rate Cut Kickoff

Amidst the market's eager anticipation and concerns about an economic "recession," the Federal Reserve initiated a rate cut as scheduled. This is the first rate cut since the outbreak of the pandemic in 2020, signaling the start of the current rate hike cycle in March 2022 and the end of the tightening cycle after the rate hike stops in July 2023. However, the magnitude of the rate cut was somewhat surprising to the market, as a 50 basis point reduction at the beginning is not common in history. Since the 1990s, there have only been three instances: January 2001, September 2007, and March 2020.

Chart: The economy is not in recession, and the rate cut is not recessionary

Source: Bloomberg, CICC Research Department

The reactions of various assets were mixed. U.S. Treasuries, gold, the U.S. dollar, and U.S. stocks all rose initially but fell after the announcement, as the 50 basis point rate cut led to a surge, only to retreat at the close due to the subsequent path and economic outlook. Before the meeting, despite limited "incremental information" on recession and rate cuts from various data such as inflation and employment, even with retail and industrial output exceeding expectations, the market's probability of the Fed's first 50 basis point rate cut significantly increased, intensifying concerns about the Fed's policy lagging behind the curve.

At the same time, U.S. stocks hit new highs, U.S. Treasuries and gold rose, and the U.S. dollar weakened, seemingly trading on a combination of "ample easing but not bad growth."

Chart: Recent loose trading driving financial conditions to ease

Source: Bloomberg, CICC Research Department

Following the Fed's rate cut, especially under the current "unconventional" rate cut and well-anticipated expectations, how assets should be traded is a question of widespread concern among investors. Based on the analysis of several previous special reports and combined with the information from this meeting, we provide the following analysis.

Meeting Information: First 50 basis point rate cut, two more rate cuts within the year, total of 250 basis points; Emphasis on no signs of recession, emphasis on higher neutral interest rates

In addition to the "unconventional" 50 basis point rate cut at this meeting, adjustments were made to the "dot plot" of future rate cut expectations and economic data forecasts. Powell, in the post-meeting press conference, emphasized the following key points regarding the future rate cut path and economic outlook 1) A 50bp rate cut is an unconventional start, exceeding market expectations. This 50bp rate cut is in line with the expectations of CME interest rate futures, but it exceeds the predictions of many Wall Street investment banks, and it is also an "unconventional" start. Historically, rate cuts starting at 50bp have only occurred in times of economic or market emergencies, such as the tech bubble in January 2001, the financial crisis in September 2007, and the pandemic in March 2020.

Chart: Historical rate cut cycles and backgrounds since 1990

Source: Bloomberg, CICC Research Department

2) Two more rate cuts totaling 50bp this year, with a total rate cut of 250bp, lower than the pre-meeting expectations of CME futures. The updated "dot plot" predicts two more rate cuts this year totaling 50bp, 4 rate cuts of 100bp in 2025, 2 rate cuts of 50bp in 2026, plus this 50bp rate cut, bringing the total rate cut to 250bp, with an interest rate endpoint of 2.75-3%.

This path is significantly lower than the slope of reaching 2.75-3% in September 2025 in CME interest rate futures trading, which may to some extent explain the rise in U.S. bond yields after the close. However, it is worth noting that due to the fluctuation of rate cut expectations and the mechanism of the "dot plot," the further away the expectation is, the less reliable it is, serving more as a comparison to current market expectations.

3) Powell repeatedly emphasizes that this 50bp rate cut cannot be used as a new benchmark for linear extrapolation [1], believing that the neutral interest rate is significantly higher than pre-pandemic levels. Considering that a 50bp rate cut could easily raise concerns about the Fed acting too slowly, Powell emphasized in the post-meeting press conference that this rate cut is not a hasty move by the Fed, but a normal response to the current labor market environment.

Furthermore, in an effort to dispel the market's linear extrapolation of the current rate cut path, Powell also emphasized that there is no fixed rate path, it can be accelerated, slowed down, or even paused, depending on the circumstances of each meeting.

Additionally, Powell also mentioned that he believes the neutral interest rate is significantly higher than pre-pandemic levels, implying that the ultimate interest rate endpoint will also be maintained at a higher level. In this economic data adjustment, the Fed raised the neutral interest rate from the previous 0.8% to 0.9%.

4) Powell emphasizes that there are no signs of a recession, the labor market is cooling, but there has been no victory on the inflation issue. Since a 50bp rate cut is more likely to raise greater economic "recession" concerns in the market, Powell also emphasized that there are no signs in the economy indicating a rising possibility of a recession Attempting to hedge market concerns in this way. The major changes in this economic data forecast are the upward revision of this year's unemployment rate forecast (from 4% to 4.4%, but stable at this level), and the downward adjustment of the PCE forecast to 2.3%.

Chart: Our preliminary calculations indicate that both overall CPI and core CPI are expected to continue to decline year-on-year.

Source: Bloomberg, Haver, CICC Research Department

Chart: Risks of weakening in the labor market may be on the rise.

Source: Haver, CICC Research Department

Overall, we believe that the Fed did see the weakness in the job market at this meeting, otherwise it would not have taken the "unconventional" step of cutting rates by 50bp at the outset, to some extent responding to the market's "call." At the same time, it is also trying to create an image of being "ahead of the market," ready to do more at any time, but not wanting to worry the market about being forced to do more due to the pressure of a sharp downturn.

From the market's reaction, not rushing to do more has indeed had an effect, explaining the decline in safe-haven assets, but the pressure of economic "recession" has not yet fully convinced the market, explaining the similar pullback in risk assets.

Path of rate cuts: Under non-recession pressure, faster rate cuts will actually slow down the subsequent path, and the easing effect has already begun to show

Despite the initial 50bp rate cut, combined with optimistic guidance and current data, we still believe that a "soft landing" is the baseline scenario. An interesting paradox is that a steeper initial slope actually slows down the subsequent rate cut path, because easing will more quickly take effect in rate-sensitive areas, such as real estate.

Of course, this means that the economic data announced in the coming months will be crucial, being able to "stand firm," as long as it does not deteriorate significantly, and even shows improvement, it will further support the message the Fed wants to convey of "faster rate cuts but no bad growth," at which point risk assets will perform better, and safe-haven assets will be nearing the end In fact, although there has been no interest rate cut yet, the easing effect has already begun to show, as reflected in:

1) Signs of simultaneous rise in quantity and price in the real estate market: After the 30-year mortgage rate followed the rapid decline of the 10-year U.S. Treasury bond to 6.4%, which is already lower than the average rental yield of 7%, the U.S. existing home sales and new home sales rebounded in July after 5 months. Existing home sales in the U.S. increased for the first time in 5 months, and leading new home sales also increased by 10% month-on-month in July. In addition, refinancing demand has also picked up as mortgage rates have declined, and the moderate rent component in the July CPI (OER, highly related to real estate expectations) rebounded after 5 months.

Chart: After the 30-year mortgage rate followed the 10-year U.S. Treasury bond to 6.2%, U.S. existing home sales turned positive.

2) Indirect financing: The proportion of banks tightening loan standards in the third quarter has dropped significantly, with the standards for residential mortgages even turning to relaxation (the proportion of banks tightening - relaxing standards is -1.9%).

Chart: The proportion of banks tightening loan standards in the third quarter has dropped significantly.

3) Direct financing: The credit spreads for investment-grade and high-yield bonds are at historical lows of 14.6% and 32.7% respectively. Coupled with the significant decline in benchmark interest rates, the financing costs for enterprises have also rapidly decreased. Against this backdrop, starting from the interest rate decline in May, the cumulative year-on-year growth of U.S. credit bond issuances from May to August increased by 20.6%, with investment-grade bonds growing by 13.7% and high-yield bonds growing by 74.5%.

Chart: The credit spreads for investment-grade and high-yield bonds are at historical lows of 14.6% and 32.7% respectively Data source: Bloomberg, Haver, CICC Research Department

Chart: From May to August, the issuance of investment-grade bonds in the United States increased by 13.7%

We statically calculate that if monetary policy returns to neutral, the high and low points of the 10-year US Treasury bond yield are 3.8% and 3.5% respectively (neutral rate 1.4% + inflation expectation 2.1% + term premium 0-30bp).

Chart: Assuming r* is at 1.4%, inflation expectation is 2.1%, and term premium is around 0-30bp, the US bond yield is in the range of 3.5%-3.8%

Chart: Considering spread pressure and financial risks, the Fed may only need to cut interest rates by around 125-175bp

Data source: Bloomberg, CICC Research Department Of course, if the current monetary policy needs to break free from restrictive constraints to address the issue of high financing costs in various sectors, the required rate cut may actually be smaller. Currently, financing costs in various sectors have already significantly decreased, especially below the investment return rate, as reflected in the mortgage rates for residents and the credit spread for corporate bonds mentioned earlier.

However, due to industry differences, the impact on the corporate side may be slower to manifest. At the same time, the Federal Reserve may also hope to achieve this effect more quickly with a faster initial rate cut, but it does not necessarily mean that the subsequent path will be the same. Currently, the easing financial conditions mentioned above have not yet been reflected in actual macroeconomic data, which is both the "gap between growth slowdown and policy easing" and the reason for the confusion and volatility in market expectations during this stage.

Chart: Correspondence between corporate financing costs and investment return rates with a 10-year U.S. Treasury yield of 4.3%

Source: Bloomberg, CICC Research Department

How to trade rate cuts? Trade easing instead of recession; gradually switch from denominator assets to numerator assets; short-term bonds, real estate chains, and industrial metals are worth paying attention to; assess the effectiveness of China's impact transmission

Looking at the general patterns of historical rate cuts, we have summarized the performance of various assets in each rate cut cycle since the 1990s using a simple average method. Generally, before a rate cut, denominator assets (such as U.S. Treasuries, gold, small-cap growth stocks represented by the Russell 2000 and Hong Kong biotech stocks) perform well, while numerator assets perform poorly (such as copper, U.S. stocks, and cyclical sectors). However, after the rate cut, as the easing effect gradually takes effect, numerator assets gradually begin to outperform.

However, the biggest problem with simply averaging historical experiences is that it masks the differences in each rate cut cycle. Comparing historical experiences without distinguishing the macro environment not only makes no sense but also leads to misleading conclusions. The switch from denominator assets to numerator assets mentioned in the "average pattern" above depends fundamentally on the number of rate cuts needed to match the extent of economic slowdown, rather than the rate cuts themselves. Otherwise, it is entirely possible to "do the opposite." For example, during the rate cut cycle in 2019, after the first rate cut, U.S. bond yields gradually bottomed out, gold gradually peaked, and copper and U.S. stocks gradually bottomed and rebounded, achieving the switch. If one were to continue to increase positions in long-term U.S. bonds and gold at this point, it would be a complete reversal in terms of strategy.

Chart: Three rate cuts totaling 75 basis points in comparable periods like 1995 and 2019 Source: Bloomberg, CICC Research Department

Currently, the unconventional 50bp rate cut at the beginning will still make the market worry about whether future growth will face greater pressure in the short term, so the upcoming economic data is crucial. If the data does not deteriorate significantly, and even improves in some interest rate-sensitive areas such as real estate as we expect, it will convey to the market a combination of "sufficient rate cut and not bad economy," achieving a new balance, and the main theme of the market may shift to recovery trades after the rate cut.

Therefore, in the current environment, US Treasuries and gold still cannot disprove this expectation, so there may still be some holding opportunities but limited short-term space. If subsequent data confirms that the economic pressure is not significant, these assets should be exited in a timely manner; in contrast, what is more certain is short-term bonds directly benefiting from the Fed rate cut, the gradually recovering real estate chain (even driving the China-related export chain), and copper also gradually gaining attention, but currently still somewhat biased to the left side, waiting for validation from subsequent data).

Chart: Based on our liquidity model calculations, there is still a risk of retracement in the US stock market before the fourth quarter, but it does not change the re-allocation space for the recovery after the rate cut.

Source: Bloomberg, CEIC, CICC Research Department

For the Chinese market, the most important impact logic of observing the Fed rate cut is how the peripheral easing effect is transmitted, that is, how domestic policies respond in this environment. Considering the constraints of the China-US interest rate differential and exchange rate, the Fed rate cut will provide more easing windows and conditions for the domestic market, which is what the relatively weak growth environment and still high financing costs need.

Therefore, we believe that if the domestic easing intensity is stronger than the Fed, it will bring greater boost to the market. Conversely, if the magnitude is limited, which is also a more likely scenario under current constraints, then the impact of the Fed rate cut on the Chinese market may be marginal and partial, as is the case in the 2019 rate cut cycle.

Chart: The pullback actually provides an opportunity to enter rate cut trades, with more than half of the loose trades completed, while inflation trades have not yet finished Source: Bloomberg, FactSet, CICC Research Department

From this perspective, due to its sensitivity to external liquidity and the linked exchange rate arrangement, Hong Kong's stock market has greater flexibility in following interest rate cuts compared to A-shares. Similarly, at the industry level, interest rate-sensitive growth stocks (biotechnology, technology hardware, etc.), sectors with a high proportion of overseas USD financing, local dividend-paying stocks in Hong Kong, and sectors benefiting from the US interest rate cuts driving real estate demand in the export chain may also benefit marginally.

In addition, various assets may be "front-running" the interest rate cut path to varying degrees. Our calculations show that the current degree of inclusion of interest rate cuts is ranked as follows: interest rate futures (200bp) > US Treasuries (41bp) > copper (40bp) > gold (30bp) > US stocks (+25bp), which is also the main implication of our recommendation to moderately "think and act in reverse."

Chart: Our calculations show that interest rate futures currently include a total of 200bp interest rate cuts, with US Treasuries, copper, and gold including 41bp, 40bp, and 30bp cuts respectively, and US stocks including a 25bp rate hike.

Source: Bloomberg, Federal Reserve, CICC Research Department

Data as of September 18, 2024

Authors: Liu Gang (S0080512030003), Wang Zilin, Yang Xuanting, Li Yujie, Source: CICC Insight, Original Title: "CICC: Federal Reserve's 'Unconventional' Interest Rate Cut Opening"