This week is the Federal Reserve's last interest rate meeting, and the market generally expects a 25 basis point rate cut, preparing for a "pause" in January next year. Powell needs to convey multiple messages, but the biggest concern for the market is "uncertainty." Short-term interest rates have risen slightly, reflecting investors' preference for short-term bonds, while long-term bonds lack confidence due to long-term inflation worries. Overall, the inflation issue in the United States appears to be structural, and future governance will require fiscal cooperation, putting Powell at risk of being "marginalized."

Abstract

Recently, long-term rates have basically recovered the decline since the rate cut in November. From the response of interest rates, the market is pricing in two things: first, the possible "pause" next year, with current market expectations that the Federal Reserve will pause rate cuts in January next year, but there will still be about three rate cuts next year; second, the market is pricing in a "soft landing" for the U.S. economy, which is reflected in the relatively small increase in short-term rates, indicating that the yield curve has begun to widen.

From market feedback, investors believe that short-term rates are safer because the Federal Reserve will still take rate cuts. After a 25 basis point cut this week, the attractiveness of short-term bonds will further increase, making them a relatively comfortable safe haven before the end of the year. In contrast, the market lacks confidence in long-term bonds; due to concerns about long-term inflation, investors choose to "not stand under a dangerous wall," which also provides an opportunity for long-term funds to enter the market.

Overall, the inflation issue in the U.S. appears more structural and shows characteristics of being long-term. Future inflation management will require cooperation from the fiscal side, which will also somewhat weaken the functional role of the Federal Reserve, making the incoming Treasury Secretary Yellen more important. Powell faces the risk of being "marginalized."

In the September interest rate meeting, the Federal Reserve cut rates by 50 basis points and almost declared victory over inflation, which seems a bit like "there's no silver here." If the Federal Reserve had chosen a conventional 25 basis point cut at that time and maintained a cautious tone, it would not be facing the current awkward situation. Powell has to choose to cut rates this week while also stating that the road ahead will be difficult (bumpy ride) and avoiding angering Trump, which is almost a survival game of riding the waves.

Main Text

This week is the Federal Reserve's interest rate meeting week, and it is also the last interest rate meeting of the year. While the market has fully priced in a 25 basis point rate cut this week, it has also begun to prepare for a "pause" in January next year. This means that during this week's FOMC, Powell has a lot of information to convey to the market, but for the financial market, the biggest issue is not "more," but "uncertainty." Today, with "re-inflation" already fully priced in, the risk of interest rates rising again after a rate cut is actually quite lowIn the chart below, we can see the reaction of U.S. Treasury yields after the interest rate meetings in September and November. We find that after a 50 basis point rate cut in September, U.S. Treasury yields experienced a significant rebound, leading the market to lament that the Federal Reserve had made a false cut. However, after the rate cut in November, U.S. Treasury yields showed a normal decline, but recently, long-term rates have basically recovered the drop since the November rate cut. From the reaction of the rates, the market is pricing in two things: first, the possible "pause" next year, with current market expectations that the Federal Reserve will pause rate cuts in January, but there will still be about three rate cuts next year; second, the market is pricing in a "soft landing" for the U.S. economy, which is reflected in the relatively small increase in short-term rates, indicating that the yield curve is beginning to widen. Given that Trump is likely to implement a relatively loose fiscal policy after being elected, the market has certain expectations for the economy and some concerns about inflation, which are normal responses.

From the market's feedback, investors believe that short-term rates are safer, as the Federal Reserve will still take measures to cut rates. After a 25 basis point cut this week, the attractiveness of short-term bonds will further increase, making them a relatively comfortable safe haven before the end of the year. In contrast, the market lacks confidence in long-term bonds; due to concerns about long-term inflation, investors choose to avoid risky positions, which actually provides an opportunity for true long-term funds to enter the market. From this perspective, short-term bonds are safer, while long-term bonds are more speculative, which characterizes the U.S. Treasury market in the short term.

The market will certainly pay attention to Powell's speech this week, while being more concerned about his relationship with Trump. This will likely be a very interesting press conference, where Powell will emphasize the future inflation risks but also needs to manage his relationship with Trump. Overall, the inflation issue in the U.S. appears to be more structural and shows signs of becoming long-term. Future inflation management will require cooperation from the fiscal side, which will somewhat weaken the functional role of the Federal Reserve, making the incoming Treasury Secretary more important. Powell faces the risk of being "marginalized."

From this perspective, the Federal Reserve's decision to cut rates by 50 basis points at the September meeting and almost declare victory over inflation seems a bit like "there's no silver here." If the Federal Reserve had chosen a conventional 25 basis point cut and maintained a cautious tone, it likely would not face the current awkwardness. Powell has to choose to cut rates this week while stating that the road ahead will be difficult (bumpy ride) and also avoid angering Trump, which is almost a survival game of navigating through challenges.

Meanwhile, the Bank of Japan's meeting this week is almost certain to result in no change. Faced with renewed inflationary pressures, the Bank of Japan has chosen to "play Tai Chi," signaling to the market that it will raise rates in the future while trying to avoid rapid rate hikes. This means that this month's meeting is likely to be another "talking past each other," and the yen exchange rate may face some volatilityHowever, for the Bank of Japan, the relatively good fundamental performance of the Japanese economy means that it has relatively more room for maneuver in monetary policy. In addition, the market's greater focus on the Federal Reserve and Jerome Powell has actually given Ueda Kazuo more operational space.

The situation in Europe is more chaotic. Last week, the European Central Bank was the first to announce a 25 basis point cut in the key deposit rate, main refinancing rate, and marginal lending rate, marking the third consecutive rate cut. It is noteworthy that the ECB removed the statement in its monetary policy announcement that it needed to maintain rates "sufficiently restrictive for as long as necessary" to ensure a downward path for inflation, replacing it with "will follow a data-dependent and meeting-by-meeting approach to determine the appropriate monetary policy stance." From an inflation perspective, although inflation in the Eurozone has decreased, it remains at a relatively high level. The ECB's adjustment of its monetary policy stance seems somewhat aggressive, but considering the ongoing weakness of the German economy, political turmoil in France, and potential trade shocks from a Trump 2.0 era, the ECB has lowered its GDP growth forecasts for this year and next by 0.1 percentage points and 0.2 percentage points to 0.7% and 1.1%, respectively. From this perspective, it may be easier to understand the ECB's change in attitude, and the market also expects the ECB to continue cutting rates in the interest rate meetings between now and mid-2025.

In summary, the U.S. should not cut rates but has to, Japan should raise rates but is trying not to, and Europe may not need to cut rates but keeps lamenting its misfortunes like Xianglin's wife.

Author of this article: Zhou Hao S0880123060019, Sun Yingchao, Source: Guotai Junan Overseas Macro Research, Original title: "【Guotai Junan International Macro】Central Bank 'Super Week': Turn on the left light, turn right!"

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Central Bank "Super Week": Green light to the left, turn right!