• Article
• 2024-08-23

Fed's 'Unconventional' Rate Cut Starts

In the midst of the market's fervent anticipation and concerns over an economic "recession," the Federal Reserve, as expected, initiated a rate cut, marking the first since the pandemic in 2020 and signaling the end of the tightening cycle that began in March 2022 and ceased in July 2023.

However, the magnitude of the rate cut took the market somewhat by surprise; 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.

They surged after the announcement of a 50bp rate cut but closed lower due to concerns about the future path and economic outlook.

Before 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 the Fed's first rate cut of 50bp significantly increased, intensifying concerns about the Fed's policy operations being "behind the curve."

Meanwhile, the U.S. stock market returned to new highs, with U.S. Treasuries and gold rising and the dollar weakening, seemingly trading on a combination of "ample easing but decent growth."

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After the Fed's rate cut, especially with this "unconventional" cut and expectations already fully brewed, how assets should be traded is a common concern among investors.

Based on the analysis of several previous special reports and combined with the information from this meeting, we analyze as follows: The meeting's information: A first rate cut of 50bp, two more cuts totaling another 50bp within the year, with an overall magnitude of 250bp; emphasizing no signs of recession and a higher neutral rate.

This meeting, while making an "unconventional" 50bp rate cut, also adjusted the "dot plot" for future rate cut expectations and economic data forecasts.

In the post-meeting press conference, Powell conveyed the following key points regarding the subsequent rate cut path and economic outlook: 1) The 50bp rate cut is an unconventional start, partially exceeding market expectations.

This 50bp rate cut aligns with CME futures expectations but surpasses many Wall Street banks' forecasts, and it is also an unconventional start.

Historically, the start of a rate cut by 50bp has only occurred 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 magnitude of 250bp, lower than the pre-meeting CME futures expectations.

The updated "dot plot" predicts two more rate cuts totaling 50bp within the year, four cuts totaling 100bp in 2025, and two cuts totaling 50bp in 2026, adding up to the current 50bp rate cut, resulting in an overall rate cut magnitude of 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 partially explain the surge in U.S. Treasury yields after the close.

However, it is worth noting that due to the volatility of rate cut expectations and the mechanism for producing the "dot plot," the "credibility" of expectations further away from the present is worse, and it is more used 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.

He believes 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 is not a hasty move by the Fed but a normal response to the current labor market environment.

At the same time, in an effort to dispel the market's linear extrapolation of the current rate cut path, Powell also emphasized that there is no fixed rate path, which can be accelerated, slowed down, or even paused, depending on each meeting's situation.

In addition, Powell also mentioned that he believes the neutral rate is significantly higher than pre-pandemic levels, implying that the final rate terminal will also be maintained 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, with the labor market cooling, but there has been no victory on the inflation front.

Since a 50bp rate cut could also easily lead to greater economic "recession" concerns in the market, Powell also emphasized that he does not see any signs in the economy that the possibility of recession is rising, trying to hedge the market's concerns in this way.

A significant change in this economic data forecast is the upward revision of this year's unemployment rate forecast (from 4% to 4.4%, but stable at this level), and the PCE forecast was lowered to 2.3%.

Overall, we believe that the Fed indeed saw the weakness in the labor market in this meeting, otherwise, it would not have taken the "unconventional" operation of starting with a 50bp rate cut, 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 being "ahead of 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 do more urgently.

From 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 for risk assets.

The path of rate cuts: Under non-recession pressure, faster rate cuts will actually slow down the subsequent path, and the easing effect has actually begun to appear.

Although the start is a 50bp rate cut, combining optimistic guidance with current data, we still believe that a "soft landing" is the base case.

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 interest rate-sensitive sectors, such as real estate.

Of course, this means that the economic data released in the next few months is crucial, which can "stand up," as long as it does not deteriorate significantly, and even if it improves, 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 the end.

In fact, although the rate cut has not yet taken place, the easing effect has actually begun to appear, reflected in: 1) The real estate market shows signs of rising prices and volumes: The 30-year mortgage rate has quickly dropped to 6.4% following the 10-year U.S. Treasury, which is already lower than the average rental return rate of 7%.

This has led to the U.S. existing and new home sales warming up again after five months, with the U.S. existing home sales showing positive growth for the first time in five months, and the leading new home sales also increasing 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-term rent (OER, highly related to 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 for 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.

Under this background, starting from May when interest rates fell, the cumulative year-on-year growth of U.S. credit bond issuance from May to August was 20.6%, with investment-grade bonds growing by 13.7% and high-yield bonds 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 of 1.4% + inflation expectation of 2.1% + term premium of 0-30bp).

Of course, if the current monetary policy is to break free from restrictions to solve the problem of high financing costs in various segments, the actual required rate cut may be smaller.

The financing costs in all segments have already fallen significantly, especially below the investment return rate, as reflected in the aforementioned mortgage rates and corporate credit bond spreads.

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 aforementioned financial conditions have not been reflected in the actual macro hard data, which is both the "gap" between slowing growth and policy easing and the reason for market expectations confusion and volatility at this stage.

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 the rate cut cycle since the 1990s in a simple average manner.

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 appears, numerator assets begin to outperform.

However, the biggest problem with simply averaging historical experience is that it conceals 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 above about the switch from denominator assets to numerator assets depends on the degree of economic slowdown and the number of rate cuts needed to match, rather than the act of rate cuts itself.

Otherwise, it is entirely 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.Currently, the unconventional rate cut starting at 50 basis points 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, and even improves in some interest rate-sensitive sectors, such as real estate, as we expect, it will convey to the market a combination of "sufficient rate cuts and not bad economy," achieving a new balance.

Subsequently, the market's main focus may shift to post-rate cut repair transactions.

Therefore, in the current environment, U.S. Treasuries and gold still have some holding opportunities under this expectation, but the short-term space is limited.

If the subsequent data confirms 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 also gradually attracts attention, but it is still somewhat left-sided at present and needs to wait for subsequent data to confirm.

For the Chinese market, the main logic of observing the impact of the Fed's rate cut is how the peripheral 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, it will bring greater stimulation to the market.

On the contrary, if the magnitude is limited, it is also a more likely situation under current reality 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 2019 rate cut cycle.

Starting from this perspective, Hong Kong stocks, due to their sensitivity to external liquidity and the reason for following the rate cut under the linked exchange rate arrangement, have 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, Hong Kong local dividends and even real estate, as well as the export chain benefiting from the U.S. rate cut driving real estate demand, may also benefit marginally.

In addition, various assets may "run ahead" to some extent on the path of rate cuts.

We calculate that the degree of discounting the rate cut expectation is currently 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 reverse" to a certain extent.