Institutional Interpretation: The Most Comprehensive Interpretation of the Federal Reserve, Can It Cut Interest Rates Again?
How many more rate hikes can the Federal Reserve implement, and what will the pace be? How will the policies of Trump, who takes office on January 20, affect the Federal Reserve's decisions?
Source: CICC Insight.
At the conclusion of the December FOMC meeting that ended early this morning Beijing time, the Federal Reserve lowered interest rates by 25 basis points as expected, bringing the benchmark rate down to 4.25% to 4.5%, fully in line with expectations. However, compared to the anticipated rate cut itself, the focus of this meeting was on how the Federal Reserve will cut rates in 2025 in the face of policy and economic uncertainties following Trump's inauguration. This will directly determine the subsequent rate cut path and asset trends, especially since U.S. stocks are already at high levels after a sustained short-term rise, and other assets are also at a bottleneck after experiencing the "Trump trade" following his election.
The "dot plot" from this meeting was more hawkish than the market expected, indicating only two rate cuts in 2025 (the September dot plot expected four cuts, while the market expected this to be reduced to three), which directly led to significant asset volatility, with U.S. stock indices dropping by varying degrees of 3%, U.S. Treasury yields and the dollar quickly rising to 4.5% and 108, respectively, and gold also falling by 2%. CME interest rate futures have directly revised the expectation for rate cuts in 2025 down to one. In our December 9 report titled "How Much Room Is Left for U.S. Stocks?," we pointed out that short-term attention needs to be paid to the "risks that have emerged from rising."
From an expectation perspective, the market has been continuously revising down rate cut expectations since the extraordinary cut in September, reflected in the sustained rise in U.S. Treasury yields. This is also why we suggested that rate cut trades should be "done in reverse" (see "The Federal Reserve's 'Unconventional' Rate Cut Start"). In a sense, the Federal Reserve has adjusted rate cut expectations to another "extreme" from the perspective of "correcting" expectations, leaving room for subsequent operations (first, tightening financial conditions again will reflexively suppress growth, and second, it provides "excess capacity" for potential inflationary policies following Trump's inauguration). The market is similar; it needs to digest overly exuberant emotions to facilitate more sustainable rises, providing another opportunity to "do it in reverse."
Looking ahead, how many more rate cuts can the Federal Reserve make, and what will the pace be? How will Trump's policies after his inauguration on January 20 affect the Federal Reserve's decisions?
Chart: Current CME interest rate futures imply only one rate cut in 2025
What message did this meeting convey? Hawkish rate cut; a 25bp rate cut, with rate cut expectations for 2025 reduced to 2 times
A 25bp rate cut brings the benchmark interest rate down to 4.25%-4.5%, in line with expectations. This rate cut fully met expectations, as the weaker non-farm data in November, falling service prices, and rents provided the Federal Reserve with a "justification" for the rate cut. Prior to the meeting, the probability of a rate cut in CME interest rate futures had risen to over 90%, so it was not the main focus of market attention and trading.
Hints at a slowdown in future rate cuts, more hawkish than expected. Compared to the fully expected rate cut, the Federal Reserve conveyed a more hawkish signal regarding the pace of future rate cuts, suggesting that the pace of future cuts may slow down. 1) The "dot plot" expects only two rate cuts in 2025 (3.75-4%), fewer than the market's expectation of three; 2) In the meeting statement, the Federal Reserve slightly added wording considering "magnitude and timing," indicating that future rate cuts may slow down. 3) During the press conference, Powell continuously hinted that the pace of future rate cuts may slow, stating that the current policy has become "now significantly less restrictive" due to the 100bp rate cut since September, and that future actions will be "more cautious" and "moving slower." In the path of future rate cuts, there will be more focus on inflation trends (implying the need to pay attention to the impact of Trump’s policies on inflation paths).
Chart: The number of rate cuts in 2025 reduced from 4 times in the September dot plot to 2 times
Source: Federal Reserve, China International Capital Corporation Research Department
Upward revision of inflation and growth forecasts, downward revision of unemployment rate levels. This FOMC meeting adjusted the forecasts for future economic data, correcting the downward revisions made in September due to recession concerns. The actual GDP growth rate and PCE inflation level for 2025 were revised up from 2% and 2.1% in September to 2.1% and 2.5%, respectively, while the unemployment rate was revised down to 4.3% (from the September forecast of 4.4%). This aligns with our views in the 2025 outlook ("2025 Outlook: The Road to Restarting the Credit Cycle"), which suggests that under the baseline scenario of a soft landing, employment data will not be too poor, with the unemployment rate likely maintaining around 4.3%; inflation data may bottom out and rebound in mid-2025Further adjustment of the neutral interest rate. On December 7, the President of the Cleveland Federal Reserve stated that "interest rates may be close to neutral levels" and that there is a need to gradually slow down the pace of interest rate cuts. In this meeting, the Federal Reserve further raised the neutral interest rate from 0.9% in September to 1%, narrowing the gap with the actual interest rate (2.3%) by another 10 basis points to 1.3 percentage points.
Chart: The gap between the neutral interest rate and the actual interest rate has further narrowed by 10 basis points to 1.3 percentage points.
Source: Haver, Federal Reserve, China International Capital Corporation Research Department
Future policy path? Interest rate cuts are still possible, but the Federal Reserve needs time to observe; now hawkishness can provide space for subsequent cuts
In the current soft landing scenario, the Federal Reserve needs to balance the fundamentals and the inflationary pressures that may arise from Trump 2.0. Currently, there are two main constraints: 1) On one hand, the degree of restriction from interest rates is not deep. The difference between the financing costs and investment returns that measure whether various sectors can open up their credit cycles is not large, which leads the Federal Reserve to maintain the pace of interest rate cuts. If too slow, it will suppress the speed of economic recovery, but if too fast, it may "overdo it," causing demand to recover rapidly and triggering uncontrollable inflation. Therefore, after recent interest rate cuts, the Federal Reserve may assess that the pace has been too fast, and after addressing previous recession concerns, it needs to pause temporarily to prevent moving too quickly. 2) On the other hand, after Trump's victory, the "risk" quickly shifted from recession to inflation, and the Federal Reserve also needs to evaluate the impact of its policies. Although Powell did not directly state this in the meeting, he hinted that the effects of tariffs and other factors still need to be observed, and some committee members have already incorporated preliminary assumptions about future policies into their policy path considerations.
Chart: Because the effects of easing will act more quickly in interest rate-sensitive areas, such as real estate.
Source: Haver, China International Capital Corporation Research Department
The timing and path of future interest rate cuts depend on two factors: first, the natural economic path. In our report "2025 Outlook: The Road to Restarting the Credit Cycle," we deduced that the U.S. economy and inflation path based on the credit cycle will generally bottom out and turn around in mid-2025. Driven by the decline in rents, inflation and core inflation will continue to decline in the first half of 2025 and then rise again in the second half. Second, the impact of Trump's policies. Inflationary policies (such as the scale of deporting illegal immigrants and the increase in tariffs) can be implemented more quickly due to procedural reasons after Trump takes office, but we expect that Trump himself may also have constraints on inflation to prevent it from affecting the election situation in mid-2026Therefore, inflationary policies may not be introduced in an overly aggressive manner. On the contrary, growth-oriented policies, such as the tax reform supported by Treasury Secretary nominee Basant, may be rolled out more quickly (《 The Rhythm and Nodes of Trump's Deal》). The January meeting may be a key point, and after Trump takes office on January 20, he may first sign a series of executive orders.
Therefore, the likelihood of a rate cut at the January FOMC (January 29) is already very low, but based on the above considerations, if inflationary policies are introduced moderately after Trump's election, there may still be a window for rate cuts in the first half of the year. Conversely, if policies are pushed too aggressively, leading the Federal Reserve to assess a significant risk of inflation rising sharply, the pace of rate cuts may be further delayed.
Chart: Under the baseline scenario, we expect to see a turning point in macro growth data by mid-2025.
Source: Haver, Federal Reserve, China International Capital Corporation Research Department
However, we also suggest not to take rate cut expectations to the other extreme. From the perspective of current policy restrictions, there is still room for rate cuts unless the second scenario mentioned above occurs. Since the beginning of this year, expectations for rate cuts have fluctuated repeatedly. In September, the market briefly triggered recession concerns due to the employment market, leading to expectations that rate cuts would start at 50 basis points, totaling over 200 basis points, which has now reduced to just one remaining (CME interest rate futures). This also reminds us that overly linear extrapolation following market thinking often leads to problems, which is why we have consistently suggested to "think and act in reverse" (《 Rate Cut Trading Manual》).
The logic behind this is that excessive overdrawing of expectations often leads to overshooting, and that the reflexivity of interest rates and financial conditions affects the fundamentals. For example, the recent resilience of economic data and inflation mentioned by the Federal Reserve is precisely due to the rapid decline of long-term government bonds to 3.5% driven by previous recession concerns, which has facilitated financial conditions (《 Federal Reserve's "Unconventional" Rate Cut Start》) Conversely, the current hawkish rate cuts, by raising interest rates and tightening financial conditions, may lead to a weakening of future data and inflation, thereby providing room for further rate cuts. In fact, since the Federal Reserve cut rates by 100 basis points in September, the 30-year mortgage rate has risen from 6.1% to 7%, following the 10-year U.S. Treasury yield. Therefore, a seemingly convoluted or even contradictory conclusion is that being "hawkish" now can provide space for subsequent "cuts."
Chart: Recent U.S. Treasury yields have returned to around 4.4%, leading to tighter financial conditions
Source: Bloomberg, China International Capital Corporation Research Department
Looking back at historical experiences since 1990, the Federal Reserve paused rate cuts in August 1989 and August 1995 to assess subsequent growth conditions and determine the pace and intensity of rate cuts.
Chart: After the "preemptive" rate cut in July 1995, the Federal Reserve held steady for three consecutive meetings until the U.S. government shut down twice due to a failure to reach an agreement on the new fiscal year's budget, at which point it decided to cut rates again by 25 basis points in December 1995.
Source: Bloomberg, China International Capital Corporation Research Department
► During the rate cut cycle from 1989 to 1992, the rate cuts began in June 1989 against the backdrop of a decline in money supply and inflationary pressures, but after two cuts, they were halted, indicating a reduced probability of economic recession, until the October savings and loan crisis led to a significant drop in U.S. stocks, prompting further cuts.
► In the rate cut cycle from 1995 to 1996, similar to the 1989 rate cuts, the main reasons for the Federal Reserve's shift were slowing growth and declining industrial metal prices. The factors triggering the July 1995 rate cut included rising unemployment and contracting PMI. After the "preemptive" rate cut in July 1995, the Federal Reserve held steady for three consecutive meetings until the U.S. government shut down twice due to a failure to reach an agreement on the new fiscal year's budget, leading to another 25 basis point cut in December 1995.
How much room is there for further rate cuts? The Federal Reserve is close to completing its task, with around 3.5% being the "appropriate" level.
The essential goal of rate cuts is to lower financing costs below investment returns to restart the private credit cycle, which has been our analytical framework. Whether the market expects 8 rate cuts or just 1 now, we believe that 3-4 cuts (currently 2-3 cuts) is a reasonable level. Based on this analytical framework, we estimate that a reduction to around 3.5% (corresponding to another 50-75 basis points cut) is appropriate.
► Monetary policy returning to neutral: Referring to the Federal Reserve's models and the average value of the dot plot for natural rates, the actual natural rate in the U.S. is around 1.4%, while PCE may be around 2.1% to 2.5%. Cutting rates 2-3 times by 25 basis points to 3.5% to 3.8% is a reasonable level► Taylor Rule: Assuming the Federal Reserve assigns equal weight to achieving inflation and employment targets in 2025, with long-term inflation and unemployment rate targets of 2% and 4.2%, respectively, and an estimated long-term federal funds rate of 3.0%. Based on our estimates of the unemployment rate and inflation level at the end of 2025 being 4.3% and 2.5% (core PCE year-on-year), the appropriate federal funds rate under the equal-weighted Taylor Rule is 3.2%, but the tail end of inflation at the end of the year and risks may lead to a smaller rate cut.
Chart: The appropriate federal funds rate under the equal-weighted Taylor Rule is 3.0%
Source: Haver, CICC Research Department
What impact does this have on assets? Do the opposite, think the opposite; the rise in U.S. Treasury yields provides trading space, and U.S. stocks can be re-entered after a pullback.
Do the opposite, think the opposite. In the short term, wait for new catalysts, and in the medium term, strengthen the pro-cyclical direction. Recently, as the U.S. dollar and Treasury yields have risen, U.S. stocks, especially technology stocks, have also been hitting new highs, leading to overly optimistic market expectations. The significant drop in rate cut expectations has caused asset pullbacks, which in this sense may not be a bad thing, as digesting overly optimistic expectations is conducive to more sustainable increases. This was the case in 1995 when the Federal Reserve stopped cutting rates for half a year; U.S. stocks pulled back while Treasury yields rose, but it also provided opportunities for trading again. In terms of timing, January 20th after taking office is a key point, as various policies were introduced on Trump's inauguration day, U.S. stock performance in the fourth quarter began, and the signals from the FOMC on January 29th are also worth paying attention to.
► U.S. Treasury yields have bottomed out, but levels above 4.5% can provide trading opportunities. We have consistently pointed out that the realization of rate cuts may actually mark the low point for long-term U.S. Treasury yields, which have already passed their lows, and the bottom will gradually rise. The trend of the bottom rising is just that. However, after a rapid increase, it will also provide trading opportunities. Combining the latest neutral interest rates, we estimate that the reasonable center for long-term U.S. Treasury yields is 3.9-4.1%.
Chart: We believe that cutting rates 2-3 times by 25 basis points to 3.5%~3.8% is a reasonable level.
Source: Haver, Federal Reserve, CICC Research Department
Chart: The realization of rate cuts may actually mark the low point for long-term U.S. Treasury yields; the short-term low has passed, and short-term overextension may provide trading opportunities.
Source: Bloomberg, CME, CICC Research Department► Short-term focus on "risks that have risen" in the US stock market, but pullbacks can be re-entered. We previously pointed out in the article "How Much Room Is Left for the US Stock Market?" that in the short term, with expectations continuing to rise, US stock valuations are already at high levels, and the optimistic expectations accounted for are also considerable. Technical indicators, such as overbought conditions, are also heating up. Therefore, if some data falls short of expectations or if the sequence and extent of policy implementation after Trump's election are not as expected, it could trigger some "correction" in market sentiment. However, after a pullback, re-entry is possible, and one can wait for key nodes in policy and earnings around mid-January. Currently, major indices are basically at key support levels.
Chart: Under baseline conditions, a 10% profit growth corresponds to the S&P 500 index around 6300-6400 points.
Source: FactSet, CICC Research Department
► The US dollar is relatively strong. The natural recovery of the US economy and incremental policies after the election will support the dollar. Short-term expectations cooling will push the dollar higher. We believe that after a short-term surge, there may be some overextension, but overall it remains relatively strong, unless there is a policy intervention.
Chart: Based on global dollar liquidity indicators, we estimate that by the end of this year, the dollar will likely continue to fluctuate in the range of 102-106.
Source: Haver, CICC Research Department
► Commodities are neutrally biased towards the long side, with attention to short-term risks in gold. Copper demand is more related to China, while oil is more influenced by geopolitics and supply. From the perspective of the credit cycle between China and the US, we believe that the possibility of a significant decline from the current level is low, but the upward momentum and timing are currently unclear, requiring catalysts. Gold has long exceeded the support levels calculated by our fundamental quantitative model based on real interest rates and the dollar index, which is $2400-2600 per ounce. Even considering that geopolitical situations, central bank gold purchases, and localized "de-dollarization" demands have brought additional risk premium compensation (which we estimate to average $100-200 since the Russia-Ukraine situation), it has already exceeded that. It can still serve as a hedge against uncertainty in the long term, but we recommend a neutral stance in the short term.
Chart: Since the Russia-Ukraine situation, the average gold premium has been $100-200.
