Cutting interest rates by 50 basis points, the Federal Reserve is the ultimate big shot for the US stock market

If we start counting from the beginning of 2022, after a two-and-a-half-year cycle of US dollar interest rate hikes, the US dollar finally entered a new phase of interest rate cuts last night. In terms of the market's most concerned interest rate cut magnitude, the Fed's initial 50 basis point cut operation seems to have delivered a wave of "sweet taste in the beginning, bitter taste in the end" medicine to the market. Why is this so?

I. "Market Posture" Before the Interest Rate Cut: Expectations are a bit chaotic

Looking at the FedWatch tool, over the past two weeks, the market's expectations for how many basis points the Fed will cut interest rates have been like a roller coaster ride. The Fed says it makes decisions based on data, so the market speculates based on high-frequency macroeconomic data each time:

Just a week ago, due to the strong performance of August CPI and PPI inflation data, the market's expectation of a 25 basis point rate cut was pushed to a small probability event of around 25%. Even after the release of the core social zero 0.3% month-on-month growth, which was considered good, and with no opposition from some major media outlets to the idea of a 50 basis point rate cut by the Fed, the probability of a 50 basis point rate cut was forcibly raised to 60%.

Despite this, with expectations fluctuating back and forth, many funds in the equity market have not fully bought into the prospect of a 50 basis point rate cut. From the perspective of expectation management, this time seems to be quite chaotic.

II. Can an Interest Rate Cut be Both "Big" and "Hawkish"?

As the first interest rate cut for the US dollar entering the post-pandemic era, this interest rate cut can be summarized as both "big" and "hawkish": "big" in that it is a direct 50 basis point cut, and "hawkish" in the message conveyed during the press conference and in the dot plot, that the 50 basis point rate cut should not be linearly extrapolated, as future decisions will still be data-driven. This 50 basis point cut is just to demonstrate the Fed's determination to support the economy.

From the Fed's latest economic forecasts, it can be seen that it is guiding for two 25 basis point cuts at the remaining two policy meetings this year, bringing the rate to 4.25%-4.5%. Then, in 2025, there will be a total of 100 basis points cut, followed by another 50 basis points cut in 2026, with the nominal interest rate stabilizing between 2.75% and 3%.

Compared to the market, although the initial 50 basis point cut was larger than expected, the subsequent rate cuts are clearly slowing down. Coupled with the fact that despite some upward revisions, the neutral unemployment rate remains below 4.5%, and the continuous return to the 2% PCE and core PCE guidance, the economic forecast chart from the Fed points to a path of a "perfect soft landing" - interest rates are declining, policies are easing, but inflation is still falling, employment is still there, and economic growth is still ongoing.

However, an interesting aspect of the entire press conference was when several reporters repeatedly asked Powell if this was a "catch-up" rate cut, Powell denied falling "behind the curve" this time, and emphasized that given the current good conditions of inflation, consumption, etc., the significant rate cut is more focused on forward-looking cuts. **But he also admitted that if he had known the July employment data in advance, So in the last meeting on July 31st, it is possible that the interest rate has indeed been cut.

In the view of Dolphin, this indicates two points:

a. Among all economic data, the current unemployment rate and new job creation are the real core data, as subsequent CPI and PPI reports did not alert the Federal Reserve.

Powell pointed out that the policy goal this time is to "restore price stability without a painful increase in unemployment"; and his response to the relatively stubborn housing inflation at present, as well as the possibility that a rate cut may further prolong the progress of housing deflation: one is that after the rate cut, lower mortgage rates will help some second-hand houses flow back to the market, and the second is that housing supply is tight, which he cannot do much about, it is more of a matter for real estate developers and the government.

b. The dot plot of economic forecasts released by the Federal Reserve to some extent only reflects the Fed's wishes, and through this guidance, it allows the market to trade this wish, which does not mean that this path will be realized.

From the revisions in this economic forecast, it can be seen that the biggest adjustment in the core variables of the economy is the unemployment rate, and the significantly revised policy rate expectations are just the results caused by this core variable.

Therefore, in the next period, a key tracking point for the expected rate cut magnitude is the labor market: how is the labor participation rate? How much has labor supply increased? How much has job demand decreased? How much has the unemployment rate increased, is it in the "manageable" range below 4.5%?

Especially in the current situation where the inertia of downward revision in non-farm employment occurs every time, it is prudent to first hedge oneself, considering some reduction in the rate cut based on the magnitude of the adjustments in the past few months, at least when Powell expresses that the Fed will consider this data in this way.

Furthermore, Dolphin is not worried about the hawkish rate cut path guidance this time, the key is still to look at employment data, especially if the weakening employment data is mainly due to an oversupply on the supply side caused by excessive immigration, rather than a weakening in business job demand, then the economy may not be as weak.

III. "Fed" Opportunism? Prefers Deflation over Inflation

At this point, looking back at the Fed's operations of raising/lowering interest rates in this round of economic uncertainty: from initially qualifying inflation as "transitory", to inflation continuing to rise by the end of 2021, and it is clear that inflation will continue to rise, although the Fed acknowledged that inflation is not temporary, in the first rate hike in February 2022, it only raised rates by 25 basis points, of course, with a strong surge, its rate hike speed quickly went from 25 to 50 basis points (at once), consecutively 75 basis points four times, continuously raising to 4.5%, then slowing down to 50 basis points by the end of 2022, and entering a slower pace of consecutive four times 25 basis points rate hikes in 2023

In the face of a clear inflation outlook, the Federal Reserve has been labeled as "too late, too slow." However, when it comes to cutting interest rates, the Federal Reserve has clearly responded quickly. Starting from the rate cut signal released at the end of last year, the inflation backlash at the beginning of this year forced a delay.

By mid-year, after weakening employment, the Fed decisively cut rates by 50 basis points in September, coupled with hawkish expectations control. It seems like they hope to stabilize the inflation breakthrough through expectation control during the rate cut process. In the case of successful expectation control, the relatively quick rate cut will alleviate the cash flow pressure on blue-collar workers and the government's debt pressure.

Under the same Federal Reserve and the same leader, the hesitation to raise rates versus the decisiveness to cut rates reveals that decision-makers who hold the power over monetary life and death seem to have a much higher tolerance for inflation than for recession or deflation. For a large economy like the United States that has experienced significant economic fluctuations, this is worth pondering.

IV. Slowdown is real, but not a major slump

Let's review the core economic data from early August (the last interest rate meeting) to the present: Apart from the three employment data in June, July, and August that have been revised down significantly (both supply and demand have reasons), which are a clear trigger for rate cuts, other data since August clearly indicate an economic slowdown.

For example, the latest August retail sales, which seem weak on the surface, actually show resilience. The seasonally adjusted retail sales in August only increased by 0.05% month-on-month, seeming to stagnate. However, this is based on the high growth rate of the previous month. If we exclude categories with large monthly fluctuations such as automobiles and parts, gas stations, building materials, and food services not directly related to physical retail, the core retail sales growth is still at 0.3%, not bad compared to the 0.4% growth of the previous month.

At the same time, with the rapid pricing of rate cut expectations in the real estate market, the U.S. real estate industry has shown signs of recovery, with both building permits and new privately-owned housing starts in August showing a rebound on a month-on-month basis.

However, the trend of weakening in some industries is also evident. For example, the momentum of growth in the food services sector, as a significant part of overall consumer spending, has weakened for three consecutive months, indicating that the subsequent consumption momentum is indeed getting weaker.

In addition, from the latest released second-quarter household balance sheet, by the end of the second quarter, the overall ability of US residents to pay off debt relative to their savings on hand is gradually returning to near the historical trend line. The space for releasing consumption by squeezing savings is also shrinking.

However, government investment and consumption continue, with the US federal government creating a deficit of $380 billion in August, excluding interest payments, the real deficit injected into the real economy is also $300 billion. At this pace, Dolphin estimates that the US deficit in the third quarter may rise again.

Overall, it can be seen that in this wave of interest rate cuts, as a domestically driven economy, the demand creation in the three major demand sectors has not significantly contracted, and the household balance sheet situation remains relatively healthy. There is indeed no apparent possibility of a major economic downturn during the interest rate cut process. Overall, although this interest rate cut is substantial, it still points to a path of monetary easing + economic soft landing.

V. Finally, the interest rate has been cut, is the opportunity coming?

From the trading last night, for the unexpectedly large 50 basis point interest rate cut, the market was initially excited, but after the press conference, the market felt something was off. Although the rate cut was very dovish, the statements during the conference call were clearly hawkish, the planned subsequent interest rate cut path is relatively slow, and the policy rate was raised by 10 basis points.

With this combination of moves, the rate cut intensity is sufficient, but the market is starting to expect the rate cut pace more cautiously, and the market's rebound does not last long. If the market moves away from short-term guidance expectations, the essence of the Fed's support for employment, and the relatively positive attitude towards interest rate cuts, Dolphin believes that in the event of a possible economic weakening, loose monetary policy is still a positive factor for equity assets.

Especially in the US stock market, cyclical assets suppressed under high interest rates, such as real estate, automobiles, etc., as well as relatively cyclical assets in technology, such as internet advertising, can also be considered.

Similarly, within Dolphin's focus, and also previously mentioned Hong Kong assets, in a loose monetary environment, Hong Kong stocks are more sensitive to the US dollar's loose environment, coupled with currently low valuations, there is hope for a recovery. Moreover, due to the external interest rate cuts, it has also opened up space for lowering domestic borrowing costs, if monetary policy can be further loosened compared to the US dollar interest rate cuts, there may be room for policy efforts.

However, whether stability can be maintained after the recovery mainly depends on internal strength, that is, whether the fundamentals can hold up. Looking at the recent consumption during the Mid-Autumn Festival holiday, consumer spending is further weakening, which is not good news for most cyclical assets that Dolphin is concerned about, such as internet e-commerce, advertising, and other well-known cyclical assets

VI. Portfolio Rebalancing and Returns

Last week, the portfolio did not rebalance (as of September 15th), with a return of 2.1%, outperforming Chinese asset indices - MSCI China (-0.5%), Hang Seng Tech Index (-0.2%), and CSI 300 (-2.2%), but underperforming the S&P 500 (+4%). This was mainly due to Chinese assets further declining in the weak holiday season consumption outlook, while some funds in US stock assets had already priced in the 50 basis point rate cut.

Since the start of the portfolio testing until last weekend, the absolute return of the portfolio is 41%, with an excess return compared to MSCI China of 65%. From the perspective of asset net value, the initial virtual assets of Alpha Dolphin were $100 million, which has now fallen to $142 million.

VII. Individual Stock Profit and Loss Contribution

In the week of September 15th, due to Jensen Huang's speech at NVIDIA driving it, the entire AI stocks were rebounding. Moreover, with the rate cut at home, the market gradually started to speculate on a 50 basis point rate cut. Assets sensitive to interest rates, such as Unity and Palantir, saw high stock price elasticity stimulated by news and fundamentals.

However, in terms of Chinese assets, approaching the Mid-Autumn Festival, consumption indicators related to holidays such as baijiu and mooncakes weakened again. Also, with the typhoon landing, the consumption of wine and travel was weak, and sectors like real estate and consumption showed signs of disappointing expectations.

VIII. Portfolio Asset Distribution

The Alpha Dolphin virtual portfolio holds a total of 13 individual stocks and equity ETFs, with 5 core holdings and 8 equity assets underweighted. The rest is distributed in gold, US bonds, and US dollar cash, with a relatively high amount of cash and cash-like assets currently, considering increasing positions in the near term. As of last weekend, the asset allocation and equity asset holding weights of Alpha Dolphin are as follows:

Risk Disclosure and Disclaimer of this article: Dolphin Research Disclaimer and General Disclosure Please refer to the recent articles in the Dolphin Research Portfolio Weekly Report:

Is there still hope for Chinese concept stocks after the recent sell-off?

US Stocks: After the scare, will the music continue?

US Stocks keep exploding with "ghost stories", is there no bottom in sight?

With the economy and consumption looking good, will the Fed really cut rates in September and continue cutting three times?

Are the "brilliant" small-cap stocks in the US nourished by economic fundamentals? 《Soft Landing of US Stocks = Big Players Tighten Control + Retail Investors Scatter?》

《The Leading Engine of US Consumption is Losing Steam, Can We Still Trade a Soft Landing?》

《Deflated Social Zero, Soft Landing Economy, Will it Drag Down Chinese Assets?》

《US Fiscal Spending "Open Door", Need to Be Cautious About Trading Rate Cuts》

《US Stock Rate Cut Expectations Shoot Out "Backfire", Is it Reliable This Time?》

《Hong Kong Stocks Suddenly Change Face, Run or Stay?》《The Financialization of the U.S. Economy, Yellen and Powell as the Gatekeepers of the U.S. Stock Market?》

《Simultaneous Correction of U.S.-Listed Chinese Stocks, Who Will Seize the Opportunity?》

《The U.S. in 2024, Soft Landing or No Landing at All》