CICC: Who "made a mistake" as stocks and bonds rise together?

Behind the seemingly "chaotic" assets in March, there are three main themes: Bitcoin, gold, and copper driven by ample liquidity; interest rate, stock market, and gold driven by rate cut expectations; copper and oil driven by improving demand and secondary inflation expectations. Liquidity trading in the second quarter may face a turning point, with re-inflation clearly taking the lead, and rate cut trading gradually becoming the main theme.

In terms of asset allocation, direction is more important than timing, similar to April-May 2019. We recommend bonds before stocks, as bonds currently offer better value, US stocks are expected to face some turbulence before improving, gold has limited upside after its rally and can be re-entered after a pullback, and copper and oil driven by re-inflation need to wait for rate cuts.

Main Text

Since March, global asset performance has been fragmented and "chaotic", with trading logic behind it even contradictory at times, such as copper reflecting improving demand and re-inflation while tech stocks bet on rate cuts, US bond yields with mixed signals on rate cut expectations, and gold surging ahead. This phenomenon is not surprising, as near macro turning points, improvements in fundamentals, re-inflation, and rate cut expectations all seem to find their own support, but some are more short-term illusions, some need to rely on other prerequisites, and short-term funds and emotions will exacerbate this deviation. After the simultaneous rise and new highs of US stocks, gold, Bitcoin, and copper, it is crucial to determine which ones are overbought and overextended, and which one is the trading theme, for judging the future direction and asset selection.

Chart: Since March, overseas market asset prices have shown a more "fragmented" performance, with contradictory trading logic behind the assets

Source: Bloomberg, FactSet, CICC Research Department

After careful analysis, we believe that behind the recent chaotic asset performance lies three main themes: Bitcoin, gold, and copper driven by ample liquidity; interest rate, stock market, and gold driven by rate cut expectations; copper and oil driven by improving demand and secondary inflation expectations. Looking at the recent performance trend, liquidity expansion first drove the surge in Bitcoin, then spread to gold and copper, among other liquidity-sensitive assets, causing gold to rally even before interest rates declined and while facing concerns about secondary inflation in the face of rate cut expectations. The surge itself prompted the market to seek more upward support, such as on the basis of the logic of copper and oil supply shortages, market expectations of improved fundamentals and demand pull from re-inflation after rate cuts, unaware that the "flaw" in this logic contradicts rate cut expectations. Looking ahead, after the confirmation from the March FOMC meeting, ("[Fed rate cuts are still on the way](https://mp.weixin.qq.com/s? On November 29th, VESYNC spent HKD 5.6445 million to repurchase 1 million shares.

**biz=MzI3MDMzMjg0MA==&mid=2247715157&idx=2&sn=68dd7fb381561be12b11d61c1684d582&chksm=eadf6f92dda8e6841b746a43e44d8b9a022126a5eae3a0e46ace30f6f6fd368d7c597415d321&scene=21#wechat_redirect)》），We expect that liquidity trading will face a turning point ("Liquidity in the United States may be at a turning point"), interest rate trading is gradually becoming the main theme ("Trading strategies before interest rate cuts"), and inflation trading is too crowded. Therefore, we recommend bonds before stocks, as bonds currently offer better value for money, US stocks will face some twists and turns before performing better, gold has limited upside after a sprint, can be re-entered after a pullback, copper and oil driven by inflation also have a head start, and improvement in demand should wait until after interest rate cuts.

1. Liquidity Trading: Risk assets sensitive to liquidity surged, but financial liquidity will face a turning point in the second quarter

As we pointed out in ("Liquidity in the United States may be at a turning point"), the rapid release of reverse repurchase at the beginning of the year led to an increase in remaining liquidity, also boosting global risk appetite, especially for assets sensitive to liquidity. **From the end of January to early March, the financial liquidity indicator we constructed (approximate bank reserves) increased by 3.4%, mainly contributed by reverse repurchase agreements, coupled with events such as the approval of a Bitcoin spot ETF in the United States and better-than-expected performance of US tech stocks. As a result, Bitcoin and the Nasdaq index continued to soar, while gold and copper also benefited from the high liquidity diffusion and significant overbought conditions.

Chart: Rapid release of reverse repurchase at the beginning of the year led to an increase in remaining liquidity

Source: Bloomberg, CICC Research Department

Chart: From the end of January to early March, our financial liquidity indicator increased by 3.4%, mainly contributed by reverse repurchase agreements

Source: Bloomberg, CICC Research Department

However, this trend later reversed, with the Federal Reserve's BTFP halting and continuing balance sheet reduction, a slowdown or even slight increase in reverse repurchase agreements, and an increase in TGA fiscal deposits leading to a 2.2% contraction in financial liquidity since mid-March. This change has caused asset prices to diverge, with Bitcoin's retreat from its peak precisely indicating that liquidity was one of the main driving factors behind the previous surge. ETF funds flowing into Bitcoin this year also temporarily turned into net outflows. While gold and copper saw a modest pullback under the support of rate cut expectations and reflation trades, their gains have significantly slowed down.

Chart: Bitcoin's retreat from its peak precisely indicates that liquidity was one of the main driving factors behind the previous surge

Source: Bloomberg, CICC Research Department Chart: ETF funds flowing into Bitcoin have turned into net outflows at one point since the beginning of this year.

Source: Bloomberg, CICC Research Department

Chart: Liquidity diffusion effect once drove gold into overbought territory, with RSI approaching 85.

Source: Bloomberg, CICC Research Department

Chart: Copper futures significantly overbought, with RSI climbing to 75 at one point.

Source: Bloomberg, CICC Research Department

Looking ahead, we expect a turning point in U.S. financial liquidity in the second quarter, which will further impact related assets. Taking into account the Treasury's debt issuance plan, the Fed's balance sheet reduction pace, and changes in fiscal deposits, we estimate that financial liquidity may tighten in the second quarter, until the Fed slows down the balance sheet reduction in June to alleviate some pressure (U.S. liquidity may be at a turning point). This is expected to exert certain pressure on Bitcoin, U.S. tech stocks, and even gold and copper. We estimate that the tightening of financial liquidity may lead to an 8% pullback in U.S. stocks, with the Nasdaq being more sensitive to the comparison Chart: The current usage of reverse repurchase on the Federal Reserve's account by major financial institutions in the United States is approximately USD 0.48 trillion per day.

Data Source: Bloomberg, CICC Research Department

Chart: We estimate that financial liquidity may turn into contraction in the second quarter, until the Fed slows down part of the pressure to hedge the balance sheet in June.

Data Source: Bloomberg, CICC Research Department

II. Inflation Trading: The logic of "rising" in bulk commodities, obviously ahead of the curve, waiting for demand improvement after interest rate cuts

In addition to directly benefiting from liquidity expansion, bulk commodities such as copper, oil, and gold are also trading in anticipation of re-inflation and demand improvement, coinciding with supply disruptions caused by reduced production of crude oil and copper. The continuous higher-than-expected inflation in the United States in January and February has provided more support for this trade, with the copper CFTC contract net position turning into net long positions in early March and increasing significantly.

However, this trade faces two problems: first, the seemingly strong demand and inflation in January and February were precisely the result of the rapid decline in interest rate trades 6-7 times earlier, which has now been corrected; second, if trading demand improvement too early, it will only delay interest rate cuts, making demand improvement impossible. From the demand side, the sub-items of new orders in the U.S. manufacturing sector are still declining, and the certainty of repair in real estate and investment sectors will have to wait for the start of interest rate cuts. The improvement in existing home sales in February reflects the transactions of the past two months, which is the lagging result of the rapid decline in interest rates driving down mortgage rates. From the supply side, primary metal inventories and the inventory-to-sales ratio of U.S. manufacturers have been declining since October 2022, and crude oil inventories are also low, but price increases based solely on low inventories are not sustainable, with demand still taking precedence.

Chart: Interest rate trades 6-7 times lower in January and February, driving down mortgage rates

Source: Wind, Bloomberg, CICC Research Department

Chart: The improvement in existing home sales in February is a lagging result of the rapid decline in interest rates in the previous two months driving down loan rates.

Source: Haver, CICC Research Department

Chart: Low U.S. crude oil inventories combined with an extension of OPEC+ production cuts have led to higher oil prices.

Source: EIA, CICC Research Department

Chart: U.S. manufacturers' primary metal inventories-to-sales ratio has been declining since October 2022.

Starting from first principles, the key to improving demand lies in credit expansion. In the election year with a two-party game in the United States, it may be difficult for the government's finances to further expand. The CBO recently lowered its fiscal deficit forecast for this year from 5.8% to 5.3%, contracting by 1 percentage point from last year's 6.3%, and the financing costs for both the corporate and household sectors are higher than their respective investment returns, making it difficult to leverage significantly. Therefore, in order to restart credit expansion, it is a prerequisite for the Federal Reserve to start a rate-cutting cycle to lower financing costs. Therefore, skipping rate cuts and directly advancing demand improvement and re-inflation is clearly a preemptive move (Where is the U.S. credit cycle heading?) Chart: CBO recently lowered this year's fiscal deficit forecast from 5.8% to 5.3%, contracting by 1 percentage point from last year's 6.3%.

Chart: In the election year of the two-party game, the US government's fiscal deficit is likely to shrink compared to last year.

Chart: The financing costs for both corporate and household sectors are higher than their respective investment returns, making it difficult to significantly increase leverage.

Data Source: Haver, CICC Research Department

III. Rate Cut Trading: Will gradually become the main theme of trading until the rate cut is realized in mid-year

There are still some misconceptions in the market about this round of rate cuts, either thinking that it is not necessary to cut rates now, or assuming that once it starts, there will be a significant rate cut. Neither may necessarily be true, and simple traditional experience may not apply. Compared to a normal rate cut cycle to address significant economic downturn pressure, this rate cut is more about resolving the continuous and deep inversion of the yield curve, otherwise financial institutions will continue to "bleed." Therefore, the initiation of rate cuts does not require a significant weakening of economic data as a prerequisite, and starting does not mean continuous and significant rate cuts. From a cyclical perspective, as long as there is no further leverage in various sectors, it is difficult for demand to accelerate again. The overall direction of growth and inflation is downward. Therefore, the improvement in US demand and the risk of secondary inflation must be based on the premise of interest rate cuts ("Detailed Explanation of Financing Costs and Burdens of Various Sectors in China and the US"). Our calculations show that inflation may still fall to 3% in the middle of the year, so there is still a possibility of interest rate cuts in the middle of the year, which can also avoid interference from the third quarter elections to the greatest extent.

Chart: Current market expectations for three interest rate cuts this year

Data Source: Bloomberg, CICC Research Department

Chart: Our calculations show that inflation can still fall to around 3% in the middle of the year

Data Source: Bloomberg, CICC Research Department

At the March FOMC meeting, the Federal Reserve maintained its dot plot of three interest rate cuts unchanged ("The Federal Reserve's Interest Rate Cuts Are Still on the Way"), so as long as there is no supply-side inflation and other unexpected disturbances, interest rate cut trades will gradually become the main theme of trading Bonds offer higher cost-effectiveness. We expect the 10-year US Treasury bond yield to decrease from 4.3% to 3.5-3.8%; similar to gold and US bonds, but with limited room for further gains after the initial surge, with a range of $2100-2200 per ounce; consider entering the US stock market after volatility subsides. However, due to the limited extent of this rate cut, we believe that the window for rate cut trades will not last long, likely ending after one or two rate cuts.

IV. How will it evolve in the future: 2019 or 1995?

Since our outlook report in November last year, we have repeatedly emphasized (《Global Market Outlook 2024: Inevitable Cycles》) that given the current economic soft landing fundamentals and policy responses to prevent rate cuts, the experience of 2019 is more relevant for this cycle.

In 2019, the downward pressure on the US economy was also limited, so the Federal Reserve made three brief "preventive rate cuts" from July to September. Subsequently, driven by the start of the real estate cycle, the US economy entered a new cycle. In this context, although long-term US bond yields experienced multiple "reversals" before the rate cuts, the downward trend continued until the first rate cut in July, indicating that short-term fluctuations are insignificant in the overall direction. The direction is more important than timing, similar to April-May 2019. After the rate cuts, short-term bonds continued to decline following the rate cuts, but long-term US bonds began to rise as growth expectations gradually improved, gold peaked, so chasing US bonds and gold after the rate cuts is not very meaningful. After sideways fluctuations, US stocks are likely to gradually rise again driven by fundamentals. The US dollar may weaken briefly but overall may trend stronger, with a range of 102-106.

1995 is a stronger example (《How did the rapid rate hikes in 1994 avoid a recession?》) The interest rate cut cycle at that time was also short-lived, with a six-month gap between the two rate cuts (the first rate cut in July 1995, and the second rate cut in December 1995 due to the fiscal contraction pressure caused by the government shutdown twice). More importantly, driven by the industrial trend of the Internet revolution at that time, the U.S. stock market hardly experienced a pullback and continued to rise significantly. The U.S. dollar was also generally strong, and gold only had a temporary opportunity at the beginning of the rate cut.

Chart: Referring to the experience in 2019, U.S. bonds and gold did not finish trading until after one or two rate cuts; in 1995, the U.S. stock market continued to rise significantly under the influence of the industrial trend of the Internet revolution.

Chart: We estimate that U.S. financial liquidity may turn downward in the second quarter.

Chart: U.S. bond rate path and central estimate.

Chart: We estimate the fair range for gold to be $2,100 to $2,200 per ounce.

Source: Bloomberg, FactSet, CICC Research Department

Source: Bloomberg, CICC Research Department

Source: Bloomberg, CICC Research Department

Source: Bloomberg, CICC Research Department Chart: The US dollar may remain volatile, ranging from 102 to 106

Source: Bloomberg, CICC Research Department

Authors: Liu Gang (License Number: S0080512030003), Yang Xuanting (License Number: S0080122080405), Source: CICC Insight, Original Title: "CICC: Who is 'wrong' with the simultaneous rise of stocks and bonds?"