CICC: Key Variables at the Beginning of 2025

Since the beginning of 2025, major global assets have experienced numerous surprises and increased volatility. The US dollar index has broken through the 109 mark, reaching a new high since 2022, while US Treasury yields remain at a high of 4.6%; the China AH market has adjusted, the RMB exchange rate has fallen to 7.3, and the 10-year government bond yield has hit a historic low.

Chart 1: Various assets are influenced by the intertwining effects of Trump’s transactions and interest rate cut expectations, showing both fluctuations and divergences.

In our report last week, "How to Grasp the Main Line of 2025," we pointed out that the main line determining the direction of assets in 2025 is: on one hand, whether the internal growth points in the US can expand, and on the other hand, whether the US can converge with the external environment. The former depends on the US's own credit cycle, while the latter depends on the strength of the credit cycles between the US and other markets. Changes in these two aspects will further determine the strength of risk and safe-haven assets, as well as the relationship between US and non-US assets.

The framework for judging the above trends is based on the credit cycle ("Global Market 2025 Outlook: The Road to Restarting the Credit Cycle"). Key variables include the sequence and intensity of Trump’s policies, trends in the AI industry, and the extent of exchange rate interventions by both China and the US. At the beginning of 2025, several key changes will determine the direction of these three critical variables, which are worth noting, such as the US debt ceiling in early January, policy developments after Trump takes office at the end of January, the Federal Reserve's interest rate meeting at the end of January, and the fourth-quarter earnings period for US stocks in mid-January. Given that current asset expectations are fully accounted for, these changes will also directly determine the subsequent direction of assets.

Chart 2: The debt ceiling, interest rate meetings, Trump’s inauguration, and US stock performance in January correspond to key nodes of the trading main line and variables for 2025.

1. Debt Ceiling and Congressional Reorganization: A Quick Resolution Will Not Bring Additional Supply Shock to Treasury Bonds

The debt ceiling suspension measure passed in June 2023 will expire on January 1, 2025, thus legally reinstating the US debt ceiling constraints from January 2. Here are some details regarding the debt ceiling:

► When will the debt ceiling be truly reached: In a letter to Congress, US Treasury Secretary Yellen indicated that the federal government may reach the debt ceiling as early as January 14 [1]. After this point, until a new agreement is reached, the Treasury can only draw on cash deposits (reflected as a decrease in the TGA account) or conduct some technical unconventional operations to maintain necessary expenditures. For the market, liquidity will increase during this process as fiscal deposits are injected. ► When will X day (the date when the U.S. Treasury runs out of cash and special measures and cannot meet all payment obligations) be faced: Currently, the U.S. TGA account balance is around $720 billion. Assuming the fiscal spending and revenue levels are similar to those in the same period of 2024, it may last until mid-year.

Chart 3: The U.S. TGA account balance is around $720 billion, and assuming the fiscal spending and revenue levels are similar to those in the same period of 2024, it may last until mid-next year.

► How to solve the debt ceiling issue? On January 3, House Speaker Mike Johnson, who was re-elected during the congressional turnover, stated that the debt ceiling could be raised by $1.5 trillion through reconciliation procedures, provided that $2.5 trillion in "mandatory net spending" (mainly including net spending on Social Security, Medicare, Medicaid, etc.) is cut at the same time. After resolution, if the Treasury needs to replenish the TGA account consumed during negotiations, it often tightens liquidity by increasing bond supply.

Under the baseline scenario, considering that the Republican Party controls both houses of Congress, the difficulty of resolving the debt ceiling may be relatively small. The reconciliation procedure for resolving the debt ceiling allows the Senate to pass it with a simple majority of 51 votes (the Republican Party controls the Senate with 53 votes), and since the Republican Party is also the majority party in the current House of Representatives (219 seats vs. 215 seats for the Democratic Party), the impact is smaller compared to the period from January 19, 2023, when the debt ceiling was reached until June 3, 2023, when Biden signed the Fiscal Responsibility Act, lasting for four and a half months. If this is the case, the additional shock to bond market supply from the pressure of replenishing debt after consuming fiscal deposits will also be relatively reduced.

In addition, after January, the new Congress will convene, and the preparation of relevant bills will gradually advance, potentially initiating the repeal of related policies (such as the electric vehicle mandate). For example, before Trump took office in 2017, on January 12 and 13, the House and Senate voted to initiate the repeal process of the Obama healthcare reform, and Trump signed an executive order on healthcare reform on his first day in office. Currently, before Trump officially takes office, if we compare it to his first term, Congress could also initiate the repeal process of policies that contradict Republican ideas, such as Biden's electric vehicle mandate, during this period, and Trump also stated during his campaign that he would terminate the electric vehicle mandate on his first day in office.

II. Federal Reserve's Interest Rate Cut Path: Pause in January, still a rate cut window in the first half of the year, key to see the impact of Trump's policies

After the hawkish rate cut by the FOMC in December, market expectations for rate cuts further converged. Currently, CME interest rate futures show that the market's expectation for a rate cut in 2025 has been revised down to only one time, and U.S. Treasury yields have thus remained at a high level of 4.6%, with the dollar even reaching a new high for the period Chart 4: Current CME interest rate futures imply only one rate cut in 2025

As we analyzed in "Can the Federal Reserve Cut Rates Again?", the current U.S. economic cycle does not face significant recessionary pressures, and the Federal Reserve does not need to cut rates many times. This is because the costs and returns across various sectors in the U.S. are "very close" (for example, the current 6.9% 30-year mortgage rate is roughly equivalent to the pre-tax 7% rental yield for U.S. households), which means that financing costs can quickly stimulate or suppress demand under the actual operation or expectations driven by monetary policy. This further manifests as the repeated "swings" in U.S. Treasury yields, growth, and rate cut expectations this year, which is why we suggest "thinking and acting in reverse."

Chart 5: U.S. household mortgage rates and rental yields are close

Therefore, just as the market was overly optimistic three months ago in believing the Federal Reserve would start with a 50bp rate cut and a total of 200bp in cuts in 2024, the current belief that no cuts are possible may also be overly pessimistic and unnecessary. The essence of a rate cut is to lower financing costs below investment returns to restart the private credit cycle. Based on this analytical framework, we believe a baseline scenario of a drop to 3.5-3.75% (corresponding to 2-3 more cuts) remains appropriate. Moreover, from the perspective of the reflexivity of interest rates, the more one worries about a recession, the less likely it is to occur, and the less one expects rate cuts, the more conducive it is to actual cuts.

Chart 6: The appropriate federal funds rate under the equal-weighted Taylor rule is 3.2%, but considering inflation risks, 3.5% may be a suitable level

Chart 7: We estimate the 10-year U.S. Treasury yield expectation to be 3.6%, with an additional term premium, the central tendency of U.S. Treasury yields is 3.9-4.1%

In this context, the Federal Reserve signaling a hawkish pause in rate cuts in December is not a bad thing. First, it prevents expectations from being overly overstretched, and second, it also needs to wait for some supply shock policies from Trump’s administration to impact inflation. From our calculations of growth and inflation paths based on the U.S. credit cycle (《 [2025 Outlook: The Path to Restarting the Credit Cycle](https://mp.weixin.qq.com/s? __biz=MzI3MDMzMjg0MA==&mid=2247753574&idx=2&sn=4a5ce19e77abf51f67d7008c64e06bf8&scene=21#wechat_redirect)》), under the natural cycle, U.S. growth and inflation are expected to bottom out and rebound around mid-2025 (with the April 2025 low corresponding to overall and core CPI at 2.3% and 2.7%, respectively, and year-end figures at 2.7% and 2.9%).

Chart 8: We estimate that the overall CPI in January 2025 (2.86%) is a peak due to base effects, and it will decline smoothly from February to April 2025.

This also means that the first half of the year remains a window for interest rate cuts, and the biggest risk of the Federal Reserve "missing" this window comes from supply shocks due to Trump’s policies, such as tariffs and immigration. The key verification points for the interest rate cut path in January are:

► January employment and inflation data. Non-farm payroll data will be released on January 10, with the market expecting an increase of 153,000 jobs, lower than the previous value of 227,000; the unemployment rate is expected to be 4.2%, unchanged from the previous value. The slowdown in immigration affects new job creation, but the unemployment rate remains stable, so there is no need to overly worry about the recession risk caused by deteriorating employment conditions. CPI data will be released on January 14, and we initially estimate that the overall CPI will rebound in December 2024 (2.83% vs. 2.75% in November), while core CPI continues to decline (3.28% vs. 3.32% in November), which has limited impact on the interest rate cut path.

► The intensity of Trump’s policies. Inflationary policies after Trump took office (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 on January 20, he may first sign a series of executive orders, making the possibility of an interest rate cut at the January FOMC (January 29) relatively low. If the policies are too aggressive (such as imposing a 10% baseline tariff + a 60% tariff on China, and significantly deporting immigrants), we can make a simple linear estimate based on the results of the previous round of trade frictions. Raising the global tax rate from the current 3% to 10% could push inflation up by 1.2 to 4.7 percentage points; increasing tariffs on China from the current 19% to 60% could additionally raise it by 1.3 percentage points, which means U.S. CPI could rise from the current 2-3% to 3-4% or even higher. Under this extreme assumption, considering that Federal Reserve Chairman Powell's term will end in May 2026, in order to consolidate the achievements in combating inflation during his tenure and maintain the independence of the Federal Reserve, it cannot be ruled out that interest rate cuts may stop earlier, or even expectations of rate hikes, which would also cause significant disturbances in the market Under the baseline scenario, we believe that Trump also faces "real constraints" from inflation and market performance, thus we estimate that there can still be 2 to 3 rate cuts as a baseline (《Can the Federal Reserve Cut Rates Again?》). Currently, the rate cut expectations priced into various assets show that the CME futures expectation of only 1 cut seems overly pessimistic. By this standard, the expectations priced into U.S. stocks are relatively reasonable; the expectations priced into U.S. Treasury yields are clearly too low, providing short-term trading opportunities; the rate cut expectations priced into copper are also low, indicating room for price increases; the risk premium for gold is relatively high in the short term.

Chart 9: The expected magnitude of rate cuts over the next year priced into various assets is as follows: U.S. Treasuries < Copper < CME interest rate futures < Gold < Nasdaq < Dow Jones < Federal Reserve dot plot < S&P 500

III. Policy Strength After Trump's Inauguration: Significant Impact Both Domestically and Internationally; Inflationary Policies Are Faster, but Magnitude Faces "Real Constraints"

The presidential executive orders signed by Trump on January 20 may provide clues to his governance priorities, affecting internal growth and rate cut expectations, external tariffs, and responses to China. **In our report "Path Simulation of Trump’s Policies and Trades: Tracking the 2024 U.S. Election (Part Ten)," we pointed out that,**in terms of processes and procedures, immigration and tariffs theoretically can be expedited as they do not require congressional approval, while tax cuts need to be legislated before the expiration of provisions in 2026.**Trump mentioned many policies that could be advanced on his first day in office during his campaign and after winning, such as initiating "the largest illegal immigration deportation operation in U.S. history," increasing tariffs on countries like China and Mexico, withdrawing from the Paris Climate Agreement, ending Biden's electric vehicle mandate, and "ending the Russia-Ukraine conflict in one day," among others. Overall,the direction of the policies is inflationary, but real constraints may prevent them from being very strong.

Chart 10: Trump's Seven Core Campaign Proposals

Chart 11: Asset Impact of Trump's Policies: Interest rates up, strong dollar (if no intervention), pro-cyclical + some technology, Bitcoin; neutral for gold, neutral to slightly bullish for commodities

► Constraints of Inflation: Significant tariff increases and large-scale deportations may trigger a second inflation risk in the U.S. According to polling data, the Biden administration's approval rating on inflation issues is only 35.3%, which may be an important factor in the polarization of this election. Currently, the decline in U.S. inflation is not yet stable, and the extent of tariffs and immigration policies is likely to induce a second inflation risk. PIIE estimates that significant tariffs and large-scale deportations could cause the CPI to return to above 6% within the next 1 to 2 years. Chart 12: According to polling data, only 40.5% of people are satisfied with the Biden administration, and the approval rating on inflation issues is even lower at 35.3%.

► Time Constraints: Considerations of electoral and market constraints may be necessary before the 2026 midterm elections. Although the Republican Party achieved a "clean sweep" in this election, the 2026 Congress will again face midterm elections. Additionally, as mentioned earlier, Powell's term will end in May 2026. Therefore, under the current inflationary landscape, it cannot be ruled out that there may be certain "concerns" regarding the pace of advancement in the first two years of his term, or he may adopt other hedging measures to attempt to suppress inflation, such as increasing crude oil supply, while possibly accelerating growth-oriented policies to solidify public support, such as tax cuts.

► Moderate Officials: Nominating a Treasury Secretary may help provide some balance. Bessent's "333" concept [3] (reducing the budget deficit to 3% of GDP by 2028 to lower the deficit rate in a growth-promoting manner; increasing the actual GDP growth rate to 3% through deregulation, tax cuts, and expanding energy production; increasing oil production by 3 million barrels per day to suppress inflation) appears to be a more balanced policy and will prioritize advancing tax cuts [4].

Under the baseline scenario, inflationary policies may advance more quickly but with "realistic constraints," while growth-oriented policies may be introduced more rapidly. The State of the Union address in January and the new fiscal year budget proposal in March-April may provide further information. This will directly affect the direction of short-term assets. For example, in 2016, on his first day in office, Trump signed an executive order on healthcare reform, indicating that the repeal of Obamacare was his top policy priority. However, this policy advancement did not go smoothly, and the setback of the healthcare reform bill in March directly led to a reversal of Trump's trade from March 2017 for half a year, only restarting in September when tax reform succeeded. If Trump had prioritized tax reform or tariffs at that time, the impact on assets could have been entirely different. Therefore, if developments trend positively, it may further strengthen the performance of U.S. Treasuries, the U.S. dollar, U.S. stocks, and cyclical sectors, and vice versa.

Chart 13: Policy Path during Trump's Previous Term

Chart 14: Inflationary policies may be quickly introduced after taking office on January 20, with growth expenditure policies possibly advancing in February-March.

Chart 15: The adjustment of the healthcare reform bill has frequently faced setbacks in the next six months, leading to a phase reversal of the Trump trade since he took office in 2017.

The same applies to overseas markets; the intensity of tariffs or their impact is more important than the strength of fiscal policy for Chinese assets. 1) If tariffs are implemented gradually, for example, an initial tariff of 30-40%, which means an additional 10-20% on the current level of 19%, we expect limited market impact because this tariff level basically aligns with current market consensus expectations, and its actual impact is relatively controllable. We estimate that a deficit rate increase of about 0.5-0.7% would be needed to cope with it (《Possible Paths and Impacts of Tariff Policy: Tracking the 2024 U.S. Election (11)》). The market's reaction at that time may be more similar to the situation after the third round of tariffs in April 2019. At that time, after experiencing a continuous decline in trade friction in 2018 and a rapid recovery rebound in early 2019, the market was already prepared for tariffs. Meanwhile, under the continuous easing of policies, growth gradually stabilized in 2019. Therefore, after the third round of 25% tariffs on $200 billion was announced in April, the market, although still disturbed, maintained a range-bound trend. 2) If a maximum tariff of 60% is imposed, due to insufficient market pricing and the actual impact increasing non-linearly, the market may face significant disturbances. Currently, the market's expectation for a final maximum tariff of 60% is still insufficient and pricing is not adequate; at the same time, we estimate that under the scenario of a 60% maximum tariff, a deficit rate increase of 1.5%-2% would be needed to offset the GDP drag from exports. The current greater reliance on external demand, limited space for the exchange rate to absorb tariffs, and increased U.S. attention to transshipment may amplify the impact of high tariffs, but may also increase the necessity and intensity of internal policy hedging.

Chart 16: The current economy is more reliant on external demand.

Chart 17: The space for the exchange rate to absorb tariffs is limited.

Chart 18: The U.S. may also impose trade restrictions on other countries such as Mexico.

Chart 19: In this case, fiscal hedging is even more necessary

IV. U.S. Stock Market Q4 Earnings Season: Focus on Technology Sector Performance and Whether Growth Momentum is Widespread

The strong performance of U.S. stocks in 2024 is mainly driven by earnings contributions, especially from leading technology stocks, so whether expectations can continue to be met is crucial for market trends. Currently, the further expansion space for U.S. stock valuations is limited. Under the current inflation and interest rate cut path, we expect the reasonable central level of the 10-year U.S. Treasury yield to be around 3.9% to 4.1%. At the same time, the risk premium is also at a historical low (the LM model estimates it at the historical 30th percentile, and the HLW model estimates it at the historical 5th percentile). Therefore, earnings are the key variable for future trends and determine the future space of the U.S. stock market (《Assessing New Approaches to U.S. Stock Valuation》).

Starting in mid-January, the U.S. stock market will enter the Q4 2024 earnings season, lasting about a month. During this time, listed companies cannot conduct buybacks, and earnings performance will also affect market sentiment. According to expectations compiled by Factset, the current market consensus expects the S&P 500's net profit in Q4 to grow by 14.3% year-on-year, a significant improvement from Q3 (6.0%); the Nasdaq's net profit is expected to see a slight decline in year-on-year growth compared to Q3 (16.6%, vs. 18.8% in Q3). At the sector level, information technology is expected to maintain its lead, while consumer discretionary, industrials, consumer staples, and financials are relatively lagging. In the short term, given the current high valuations and sentiment, if earnings do not meet expectations, it may cause volatility, but in the medium to long term, it provides better entry opportunities.

Chart 20: Expected improvement in S&P 500 Q4 growth rate compared to Q3

Chart 21: Information technology growth rate expected to maintain its lead, while consumer discretionary, industrials, consumer staples, and financials are relatively lagging

V. Asset Implications: Think and Act Contrarily; U.S. Treasury Yield Surge Provides Trading Space, U.S. Stocks Can Be Re-entered After Correction

Regarding the key variables at the beginning of 2025, under the baseline scenario, we judge that the debt ceiling will be relatively smoothly resolved, Trump's tariffs and immigration policies will be relatively "moderate" after taking office, and the Federal Reserve will still have a window for interest rate cuts in the first half of the year, with slight fluctuations in U.S. stock earnings. Therefore, the U.S. credit cycle will gently restart, U.S. assets will perform well, and the Chinese credit cycle will no longer contract, remaining primarily structural. Specifically:

► U.S. Treasury yields are rising from the bottom, but yields above 4.5% can provide trading opportunities. We have consistently pointed out that the realization of interest rate cuts may actually mark the low point of long-term U.S. Treasury yields, and the low point of U.S. Treasury yields has passed, with the bottom gradually rising However, after a rapid rise, trading opportunities may also arise. We estimate that the reasonable central range for long-term U.S. Treasury yields is 3.9-4.1%.

► U.S. stocks are temporarily focused on volatility, but pullbacks can be re-entered. In our article "How Much Room is Left for U.S. Stocks?", we pointed out that in the short term, with expectations of continued support, U.S. stock valuations are already at high levels, incorporating a lot of optimistic expectations. Therefore, if performance data falls short of expectations or if policy advancement after Trump's election is constrained, it may trigger a market sentiment adjustment. However, after a pullback, re-entry is possible.

► The U.S. dollar is relatively strong. The natural recovery of the U.S. economy and incremental policies after the election will support the dollar. Overall, it remains relatively strong unless there are subsequent policy interventions.

► Commodities are neutrally biased towards the long side, with attention on short-term gold overextension. Copper demand is more related to China, while oil is more influenced by geopolitical and supply factors. From the perspective of the credit cycle between China and the U.S., we believe that the possibility of a significant further decline from the current level is low, but the upward momentum and timing are currently unclear, requiring catalysts. Gold has exceeded the $2400-2600 per ounce range supported by our fundamental quantitative model based on real interest rates and the dollar index. Even considering the additional risk premium compensation brought by geopolitical situations, central bank gold purchases, and localized "de-dollarization" demand (which we estimate has averaged $100-200 since the Russia-Ukraine situation), it has also exceeded this range. Long-term, it can still serve as a hedge against uncertainty, but in the short term, we recommend a neutral stance.

However, if the progress of the above events exceeds expectations, asset volatility may further intensify. For example, an unresolved debt ceiling could exacerbate pressure on U.S. stocks and bonds, similar to the situation in July 2023 when the debt ceiling was resolved, leading to rising Treasury yields and falling stock prices. Significant tariff increases and mass deportations after Trump's inauguration could elevate the risk of secondary inflation in the U.S., reducing domestic risk appetite and thereby constraining the upward trend of U.S. stocks, while externally suppressing the performance of emerging markets.

Authors of this article: Liu Gang S0080512030003, Wang Zilin S0080123090053, Source: CICC Insights, Original title: "CICC: Key Variables at the Beginning of 2025" Risk Warning and Disclaimer

The market has risks, and investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investment based on this is at one's own risk