Federal Reserve: How to interpret the "outcome" of interest rate cuts?

The June Federal Reserve interest rate meeting can be described as "contradictory". On one hand, the comprehensive cooling of the May inflation data released before the meeting, especially the highly watched super core inflation by the Federal Reserve, saw a month-on-month negative turn for the first time since September 2021. However, on the other hand, the good news on inflation does not seem to have "impressed" the Federal Reserve, as the market's desire for two interest rate cuts did not materialize, at least the dot plot still remains committed to a single rate cut.

Nevertheless, this conservative approach to rate cuts does not seem convincing, as the market seems to believe in the guidance of inflation data—U.S. stocks continue to hit new highs, while U.S. bond yields and the dollar have significantly declined. I may lean towards viewing the interaction between the Federal Reserve and the market from two perspectives: the medium term (a quarter or more) and the short term. In the medium term, the Fed's stance in June is not set in stone and could still change; however, in the short term, market volatility will intensify, and the pattern of "good news" in macro data being "bad news" for the market will become more apparent.

"Signal left, turn right," the contradictory Federal Reserve. The main content of this meeting's minutes did not change much compared to May. Overall, we believe there are two aspects worth noting:

Firstly, the tension over inflation has eased. Although compared to March, the Fed raised its forecast for 2024 PCE (by 0.2 percentage points), the evaluation of inflation has shifted from "a lack of further progress" in May to "modest further progress," evident in the performance of inflation data in April and May.

Secondly, rate cuts are still the mainstream view, but there is a clear divergence on the magnitude of rate cuts. The dot plot for June has changed significantly, with rate cuts still being the mainstream view (15 out of 19 officials support rate cuts), but the option of cutting rates three times or more has been ruled out. While the median suggests one rate cut, the highest number of officials support two rate cuts (8 officials), with 7 supporting one rate cut and 4 not supporting any rate cut.

I tend to believe that the signals from the June interest rate meeting may be a temporary measure, with room for further changes. A simple analysis can be conducted from three angles: fundamental comparison, policy intent, and policy threshold.

"Dreaming back to September 2023," but the current fundamentals may not be comparable. For the 2024 interest rates, the median in the June dot plot is at a level similar to September 2023, and if looking at the mean that better reflects marginal changes in interest rate policy attitudes, this June's level is even higherHowever, fundamentally, whether it is growth or inflation, it is clearly not as good as September last year. In terms of growth, the U.S. economy experienced an accelerated rebound in the third quarter of last year. According to the GDP high-frequency forecast from Atlanta, the quarter-on-quarter annualized growth rate surged from around 2% in July to over 5% in September last year, while the current quarter-on-quarter growth rate has slipped from over 4% in May to around 3%; in terms of inflation, the inflation data for August announced in early September last year exceeded market expectations, with CPI rebounding to 0.6% on a month-on-month basis, which cannot be compared with last night's data.

"Once bitten by a snake, one is scared all one's life at the mere sight of a well rope." The Federal Reserve may be aiming to avoid repeating the mistake of "prematurely popping the champagne" last year. As mentioned in previous reports, the Federal Reserve's observation window for confirming inflation changes may be extended from the previous 3 months to 4 to 6 months—because since 2023, there have been more than one instance of inflation slowing down for 2 to 3 months before accelerating again.

To see the inflation data for July (4 months from April to July), we will have to wait until August and beyond at least, so whether there will be a readjustment of the dot plot or even a direct rate cut at the September meeting is worth paying close attention to.

The threshold for a rate cut may not be as high as the market thinks. Unlike the market, the Federal Reserve may pay more attention to the future trend of inflation rather than simply following past inflation data step by step (which Powell has repeatedly mentioned in public speeches); in addition, the labor market is also an area of increasing concern for the Federal Reserve—according to the Fed's assessment, the labor market has cooled significantly, approaching pre-pandemic levels, with job vacancies decreasing significantly and employment growth slowing continuously. The turning point in the labor market may not be far off (of course, this does not consider non-standard scenarios of artificially induced recession).

Of course, in the short term, based on the Fed's tone-setting, the impact of macro data on the market will be magnified, and the situation where "good news" is "bad news" may become more common. Just as the core rise in U.S. bond yields this year comes from inflation, subsequent important data such as employment, PMI, etc., will all become important sources of asset price volatility.

(Personal opinion, for reference only, not as investment advice)

Author: Tao Chuan S0600520050002, Source: Dongwu Securities Tao Chuan, Original Title: "Federal Reserve: How to Resolve the "Knot" of Rate Cuts?"