Fed's "Unconventional" Rate Cut Begins
In the midst of the market's fervent anticipation and concerns over an economic "recession," the Federal Reserve has commenced interest rate cuts as scheduled, marking the first since the pandemic in 2020 and signifying the end of the tightening cycle that began in March 2022 and was halted in July 2023.
However, the magnitude of the rate cut came as a "surprise" to the market; a 50bp start is not common in history, with only three instances since the 1990s: January 2001, September 2007, and March 2020.
The reactions of various assets were even more entangled, with U.S. Treasuries, gold, the dollar, and U.S. stocks all experiencing initial gains followed by declines.
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After the announcement of the 50bp cut, they surged but closed lower due to concerns about the subsequent path and economic outlook.
Prior to the meeting, despite the limited "incremental information" from inflation and employment data on recession and rate cuts, and even with retail and industrial output exceeding expectations, the market's bet on a 50bp rate cut by the Fed increased significantly, intensifying concerns about the Fed's policy operations being "behind the curve."
Meanwhile, U.S. stocks returned to new highs, U.S. Treasuries and gold rose, and the dollar weakened, seemingly trading on a combination of "ample easing but decent growth."
After the Fed began cutting rates, especially with this "unconventional" rate cut and expectations already well-brewed, how assets should be traded is a common concern among investors.
Based on several previous special reports ("Interest Rate Cut Trading Manual," "New Ideas for Interest Rate Cut Trading") and in conjunction with this meeting's information, we analyze as follows.
This meeting not only made an "unconventional" 50bp rate cut but also adjusted the "dot plot" of future rate cut expectations and economic data forecasts.
Additionally, Powell conveyed several key points about the subsequent rate cut path and economic outlook during the post-meeting press conference.
1) The 50bp rate cut is an unconventional start, partly exceeding market expectations.
This 50bp rate cut aligns with CME futures expectations but surpasses many Wall Street banks' forecasts and is also an unconventional start.
Historically, rate cuts starting with a 50bp drop only occur during economic or market emergencies, such as the tech bubble in January 2001, the financial crisis in September 2007, and the pandemic in March 2020.
2) Two more rate cuts totaling 50bp within the year, with an overall rate cut of 250bp, lower than the pre-meeting CME futures expectations.
The updated "dot plot" forecasts two more rate cuts totaling 50bp within the year, four cuts totaling 100bp in 2025, and two cuts totaling 50bp in 2026.
Adding this 50bp rate cut, the overall rate cut reaches 250bp, with the terminal rate at 2.75-3%.
This path is significantly lower than the slope of CME futures trading, which expects to reach the 2.75-3% level by September 2025, which may partly explain the surge in U.S. Treasury 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 from the present, the lower the "credibility" of expectations, serving more as a comparison to current market expectations.
3) Powell repeatedly emphasized that this round of 50bp rate cuts should not be taken as a new benchmark for linear extrapolation [1], believing that the neutral 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 repeatedly emphasized in the post-meeting press conference that this rate cut was not the Fed acting hastily but a normal response to the current job market environment.
At the same time, to dispel market concerns about 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 each meeting's situation.
Additionally, Powell mentioned that the neutral rate is significantly higher than pre-pandemic levels, implying that the ultimate terminal rate will also remain at a higher level.
In this economic data adjustment, the Fed raised the neutral rate from the previous 0.8% to 0.9%.
4) Powell emphasized that he does not see any signs of recession, the labor market is cooling, but there has been no victory on the inflation front.
Since a 50bp rate cut could more easily lead to greater market concerns about an economic "recession," Powell also emphasized that he does not see any signs in the economy that the likelihood of a recession is rising, trying to hedge the market's concerns in this way.
The significant change in this economic data forecast is the upward revision of this year's unemployment rate forecast (from 4% to 4.4%, but stabilizing at this level) and the downward revision of the PCE forecast to 2.3%.
Overall, we believe that the Fed indeed saw the weakness in the job market at this meeting, otherwise, it would not have taken the "unconventional" operation of cutting rates by 50bp at the start, which also responded to the market's "call" to a certain extent.
At the same time, it is also trying to create an image of "leading the market," ready to do more at any time, but not wanting to worry the market because of the pressure of a significant recession and being forced to act hastily.
Looking at the market's reaction, not being in a hurry to do more has indeed had an effect, explaining the decline in safe-haven assets, but the economic "recession" pressure has not yet fully convinced the market, explaining the same callback in risk assets.
The path of rate cuts: Under non-recessionary pressure, faster rate cuts will actually slow down the subsequent path, and the easing effect has actually 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 base case ("The Basis for Recession Judgment and Historical Experience").
An interesting paradox is that a steeper initial slope actually slows down the subsequent rate cut path because easing will take effect more quickly in rate-sensitive areas, such as real estate.
Of course, this means that economic data announced in the following months is crucial and can "stand firm"; as long as it does not deteriorate significantly and even shows improvement, it can further substantiate the Fed's message of "faster rate cuts but decent growth."
At that time, risk assets will perform better, and safe-haven assets will be nearing their end.
In fact, although the rate cut has not yet occurred, the easing effect has actually begun to show ("New Changes in the Credit Cycle of China and the United States"), reflected in: 1) Real estate shows signs of both volume and price increases: After the 30-year mortgage rate quickly fell to 6.4% following the 10-year U.S. Treasury, it has already fallen below the average rental return rate of 7%, which has led to the revival of U.S. existing and new home sales after five months, with the first positive growth in existing home sales in five months, and the leading new home sales also increased by 10% month-on-month in July.
In addition, refinancing demand has also warmed up with the decline in mortgage rates, and the July CPI medium quantity rent (OER, highly correlated with real estate expectations) has rebounded after five months.
2) Indirect financing: The proportion of banks tightening loan standards in the third quarter has fallen significantly, with residential loan standards even easing (the proportion of tightening-easing banks is -1.9%).
3) Direct financing: The credit spreads of investment and high-yield bonds are at historical lows of 14.6% and 32.7%, respectively, and with the significant decline in benchmark interest rates, corporate financing costs have also fallen rapidly.
Against this backdrop, starting from May when interest rates fell, U.S. credit bond issuance from May to August increased by 20.6% year-on-year, with investment-grade bonds increasing by 13.7% and high-yield bonds increasing by 74.5%.
We have calculated statically that if monetary policy returns to neutrality, the high and low points of the 10-year U.S. Treasury rate are 3.8% and 3.5%, respectively (neutral rate 1.4% + inflation expectation 2.1% + term premium 0-30bp).
Of course, if the current monetary policy needs to be less restrictive to solve the problem of high financing costs at all levels, the required rate cut may be smaller.
The financing costs at all levels have already fallen significantly, especially below the investment return rate, as mentioned in the text above, such as residents' mortgage rates, corporate credit bond spreads, etc.
However, the corporate side may reflect more slowly due to industry differences, and the Fed may also hope to achieve this effect faster with a faster initial rate cut, but it does not necessarily mean that the subsequent path will be the same.
At present, the easing of the above financial conditions has not yet been reflected in the actual macro hard data, which is both the "gap" between slowing growth and policy easing and the reason for the confusion and volatility of market expectations at this stage ("New Ideas for Calculating U.S. Treasury Rates").
How to trade rate cuts?
Easing trade rather than recession trade; gradually switching from denominator assets to numerator assets; short-term debt, real estate chain, and industrial metals are worth paying attention to; the impact on China depends on whether it can be effectively transmitted.
Looking at the general rules of past rate cuts, we have summarized the performance of various assets in each round of rate cut cycles since the 1990s in a simple average way ("Interest Rate Cut Trading Manual").
Generally speaking, before the rate cut, denominator assets (such as U.S. Treasuries, gold, Russell 2000, and small-cap growth stocks represented by Hong Kong biotech stocks) perform well, while numerator assets perform poorly (such as copper, U.S. stocks, and cyclical sectors), but after the rate cut, as the easing effect gradually emerges, numerator assets gradually start to outperform.
However, the biggest problem with simply averaging historical experience is that it covers up the differences in each rate cut cycle.
Historical experience comparison without distinguishing the macro environment is not only meaningless but also misleading.
The "average rule" mentioned in the text about the switch from denominator assets to numerator assets depends on the degree of economic slowdown required to match the number of rate cuts, rather than the act of rate cuts itself, otherwise, it is completely possible to "do the opposite," such as in the 2019 rate cut cycle, after the first rate cut, U.S. Treasury rates gradually bottomed out, gold gradually peaked, copper and U.S. stocks gradually bottomed out and rebounded, achieving the switch.
If you continue to add long-term U.S. Treasuries and gold at this time, the operation will be completely reversed.At present, the unconventional interest rate cut starting at 50bp will still cause the market to worry about whether future growth will face greater pressure in the short term.
Therefore, the next few economic data points are crucial.
If the data does not deteriorate significantly, or even improves in some interest rate-sensitive sectors such as real estate, as we expect, it will send a signal to the market that "the degree of rate cut is sufficient and the economy is not bad," achieving a new balance.
Subsequently, the market's main focus may shift to the repair transactions after the rate cut.
In the current environment, U.S. Treasuries and gold still cannot falsify this expectation, so they may still have some holding opportunities but with limited short-term space.
If the subsequent data confirm that the economic pressure is not significant, then these assets should be exited in a timely manner.
In contrast, what is more certain is the short-term debt that directly benefits from the Fed's rate cut, the gradually repaired real estate chain (even driving China's related export chain), and copper, which is also gradually worth paying attention to, but is still somewhat on the left side at present and needs to wait for the next few data points to verify ("New Ideas on Interest Rate Cut Trading").
For the Chinese market, the main logic of observing the impact of the Fed's rate cut is how the external easing effect is transmitted in, that is, how domestic policies respond in this environment.
Considering the constraints of the China-U.S. interest rate spread and exchange rate, the Fed's rate cut will provide more easing windows and conditions for the domestic market, which is also needed in the current relatively weak growth environment and still relatively high financing costs.
Therefore, we believe that if the domestic easing is stronger than the Fed's, it will bring greater stimulation to the market.
On the contrary, if the magnitude is limited, which is also a more likely situation under the current realistic constraints, then the impact of the Fed's rate cut on the Chinese market may be marginal and local, as was the case in the rate cut cycle in 2019.
Starting from this perspective, the Hong Kong stock market, due to its sensitivity to external liquidity and the Hong Kong's follow-up rate cut under the linked exchange rate arrangement, has greater elasticity than A-shares.
Similarly, at the industry level, growth stocks sensitive to interest rates (biotech, tech hardware, etc.
), sectors with a high proportion of overseas dollar financing, local dividends in Hong Kong stocks, and real estate, as well as the export chain benefiting from the demand for real estate driven by U.S. rate cuts, may also benefit marginally.
In addition, various assets may "run ahead" of the rate cut path to varying degrees.
We estimate that the degree of incorporation of the rate cut expectation is in the order of interest rate futures (200bp) > U.S. Treasuries (41bp) > copper (40bp) > gold (30bp) > U.S. stocks (+25bp), which is also the main meaning of our suggestion to "think and act in the opposite way."