CICC estimates: The equilibrium interest rate for US bonds should be around 4%, corresponding to a rate cut of 100-150 basis points

Abstract

Since 2023, the market has been wondering why the US interest rates are so high, yet the economy continues to show resilience? By deducing the reasons from the results, an intuitive explanation is that the current interest rates may not be as restrictive as they seem. Why is this the case? The financing cost and investment return framework we introduced last year can better explain this issue. This perspective also gives us a new way to calculate US bond rates.

I. Practical Significance of Financing Cost and Investment Return Framework

Monetary policy influences the credit cycle by adjusting the level of financing costs. Therefore, compared to simply deducing based on the monetary cycle, the financing cost and investment return are a more effective measurement method and framework. For the overall economy, it can be measured by real interest rates and natural interest rates; for the household sector, the difference between rental returns and mortgage loan rates leads housing sales; for the corporate sector, ROIC leads fixed asset investment compared to industrial and commercial loan rates. Currently, these rates are basically flat, indicating that the degree of monetary policy restriction is not high. This is also why the expectation of rate cuts drives rates down, and some sensitive real demand entities such as real estate will improve.

II. What should be the reasonable US bond rate? How much rate cut is enough?

We believe that the purpose of this round of Fed rate cuts is to return rates to a neutral level, rather than due to an economic recession. Based on this idea, we only need to calculate the extent to which the financing cost needs to be reduced to the investment return rate, and then calculate the position of the 10-year US bond based on the relationship between financing costs and long-term bond rates, and finally make the interest differential positive to deduce the extent of the Fed rate cut. We calculate that a US bond rate of around 4% can achieve equilibrium, corresponding to a rate cut of 100-125 basis points.

III. What insights does this have for assets? More than half of the loose trading, the rate cut realization is also approaching the end

The above calculation results imply that the rate cut trading is not over yet, but due to the limited rate cut and market anticipation, the rate cut trading may have passed the halfway mark, and the rate cut realization is also approaching the end. After the rate cut realization, assets will gradually shift towards benefiting from reflation.

Main Text

Since 2023, the market has been puzzled by a question: why has the Federal Reserve raised interest rates at the fastest pace since the 1990s, with US bond rates reaching historical highs since the financial crisis, yet the US economy continues to show resilience? From the deduction of real results, we can provide an intuitive explanation that the current level of interest rates may not be as high or as restrictive as perceived, or have been maintained in a restrictive range for long enough.

Chart: The Federal Reserve has raised interest rates at the fastest pace since the 1990s, with US bond rates reaching historical highs since the financial crisis

Source: Bloomberg, CICC Research Department

Why does this situation of high interest rates but insufficient restrictiveness occur? Our analytical framework introduced last year clearly indicates that when analyzing the effectiveness of monetary policy, we should not only focus on financing costs, but also consider investment returns and compare the relationship between the two (《Detailed Analysis of Financing Costs and Burden in China and the United States》). From a macroeconomic perspective, a restrictive interest rate level implies that it needs to exceed the natural rate (the level of interest rates when the economy and prices are stable and balanced); from the perspective of various sectors of the economy, a restrictive interest rate level requires that their financing costs be higher than the investment return rate. This perspective also gives us a new way to calculate the U.S. bond interest rate, that is, what should be the balance of financing costs and investment return rates, rather than simply comparing historical interest rate levels.

Practical significance of the financing cost and investment return framework: Compared to simply looking at the absolute level of interest rates, it can better judge credit and economic cycles.

The reason we bypass simply looking at monetary policy and interest rate levels themselves, and instead take a different approach from the perspective of financing costs and investment returns, is because monetary policy affects the credit cycle (the leverage willingness of various sectors) by adjusting the level of financing costs, ultimately influencing the economy. Taking the current Fed rate hike cycle as an example, although the rate hike amplitude is considerable, the speed is fast, and the interest rates are high, due to the investment return rate also rising, the credit cycle has not significantly tightened as a result, and has even loosened multiple times due to financial risks and market front-running of rate cut expectations, such as the significant rate decline after the Silicon Valley Bank incident in 2023 and the liquidity provided by the Fed, as well as the market's significant front-running of rate cut expectations in the first quarter of 2024.

Chart: Although the Fed's rate hike amplitude is large and interest rates are high, the credit cycle has not significantly tightened due to the investment return rate also rising.

Source: Haver, CICC Research Department

Therefore, compared to simply deducing based on the monetary cycle, financing costs and investment returns are a more effective measurement method and framework. If monetary policy needs to tighten to suppress demand and inflation, the premise of financing costs exceeding investment returns is important; On the contrary, for the credit cycle to reopen, it is necessary to see financing costs fall below investment returns.

In practical operations, we determine what indicators to use to measure their respective financing costs by analyzing the sources of funds for various sectors in the United States. Specifically,

► At the overall economic level, financing costs can be measured by real interest rates, and long-term investment returns can be approximated by natural interest rates. In terms of effects, natural interest rates lead the actual interest rates by about a quarter ahead of the U.S. ISM Composite PMI index, the leading relationship is not stable, and the correlation coefficient of 0.46 is not too high. This also indicates that due to the different financing environments of various sectors and links in the real economy, a more rigorous and effective method is to separately calculate the financing costs and investment returns of each sector.

Chart: The natural interest rates lead the actual interest rates by about a quarter ahead of the U.S. ISM Composite PMI index, with an unstable leading time

Source: Federal Reserve, Haver, CICC Research Department

► For the household sector, credit is mainly in the form of mortgages (accounting for about 70%), with the financing cost being the mortgage interest rate, and the investment return rate can be measured by the rental yield. The rental yield leads the mortgage interest rate by about a month ahead of U.S. home sales volume, with a correlation coefficient of 0.76, indicating the effectiveness of this indicator.

Chart: The rental yield leads the mortgage interest rate by about a month ahead of U.S. home sales volume

Source: Haver, CICC Research Department

Chart: Non-financial enterprise ROIC - commercial loan interest rate leads the non-residential fixed asset investment month-on-month growth rate by about a quarter

Source: Federal Reserve, FDIC, Haver, CICC Research Department

► For the corporate sector, the sources of funds are more diverse and complex, such as corporate bonds (about 40%), equity (13%), and commercial loans (14%), etc. Large enterprises rely more on direct financing, while small enterprises rely more on bank loans. For all types of enterprises, the common financing exposure comes from bank loans. We select data on all enterprises disclosed by the FDIC and the Federal Reserve, with the cost being the commercial loan interest rate and the investment return rate using the non-financial enterprise ROIC. The non-financial enterprise ROIC - commercial loan interest rate leads the non-residential fixed asset investment month-on-month growth rate by about a quarter, with a slightly lower correlation coefficient compared to the more single financing structure of residential home purchases The ratio is 0.53, which basically indicates the situation.

Currently, the financing costs and investment return rates of various sectors in the United States are "basically balanced," indicating that the degree of monetary policy constraints is not high. This is why the market slightly anticipates interest rate cuts to drive down rates, leading to improvements in sensitive real estate demand. For example, real interest rate of 2.1% vs. natural interest rate of around 1.3% [1], residential mortgage rate of 7% vs. rental yield of 6.7%, commercial loan rate of 6.6% vs. ROIC of 5.9%. It is easy to see that the current degree of tightening by the Federal Reserve is "just right," so even a slight fluctuation in rates can cause the economic cycle to move up or down, resulting in fluctuating data, with strong data leading to rate hikes and weak data leading to rate cuts in a cyclical manner.

What should be the reasonable U.S. bond rate? A 4% long-term rate can reach equilibrium, corresponding to a rate cut of 100-125bp

In traditional U.S. bond rate calculation methods, it is necessary to separately assess the rate expectations (i.e., neutral rate, risk-neutral rate, the rate level without considering holding period risk) and term premium (the compensation for holding risks for a longer period). However, in the new framework of matching financing costs and investment return rates as mentioned above, the central point of the long-term rate should align with financing costs, further deducing the extent of rate cuts needed for the Federal Reserve to achieve this goal.

We believe that the background of this round of rate cuts was not due to economic recession, but rather, in a situation where inflation is basically under control, adjusting monetary policy to a neutral level aligned with the investment return rate is sufficient, as mentioned by Powell at the December FOMC press conference last year [2], stating that rate cuts are to return to neutrality. Too low rates may lead to economic rebound and secondary inflation risks, as seen in the first quarter of this year when real estate and manufacturing PMI demand temporarily recovered due to rapid rate declines. Conversely, excessively high rates may bring potential credit risks and financial system pressures. Therefore, in this scenario, rates only need to reach an equilibrium level, which is also the goal the Federal Reserve hopes to achieve.

Based on this line of thinking, we take a different approach. First, we calculate how much each sector's financing costs need to be reduced to match the investment return rate, then calculate the equilibrium point of the 10-year U.S. bond rate through the relationship between financing costs at each stage and the long-term government bond rate, thereby reversing the inverted rate curve to positive and deducing the extent of rate cuts needed by the Federal Reserve. Specifically,

Firstly, by reducing the financing costs of each sector to near the investment return rate, we calculate that the equilibrium point of the 10-year U.S. bond rate is around 4%.

► Overall Economy: As analyzed above, the 10-year U.S. bond rate can be broken down into term premium and rate expectations, with rate expectations further broken down into real rate expectations and inflation expectations. Since the beginning of this round of Federal Reserve rate hikes, we have found that the 10-year U.S. bond rate expectations have maintained a close relationship with CME rate futures expectations for the federal funds rate one year later, with the values being almost identical. Therefore, 1) if we assume that real rate expectations fall back to the natural rate, returning to equilibrium The estimation model for the natural interest rate shows that the LW and HLW models of the New York Fed estimate values of 1.2% and 0.7% respectively, while the LM model of the Richmond Fed estimates a value of 2.5%. The Federal Reserve's dot plot shows 0.8% (2.8% long-term rate - Fed's estimated 2% long-term inflation), with the average around 1.3%. Inflation expectations have remained stable at 2.2% to 2.5% since 2023. Term premium, influenced by factors such as issuance, has stabilized around 0-30bp due to the moderate issuance scale in 2024, lower than the significantly higher-than-expected issuance in the same period last year. Combining the above three sub-items, the central 10-year U.S. bond rate is around 4%.

Chart: Expectations for the 10-year U.S. bond rate and market expectations for the federal funds rate one year later have always maintained a close relationship, with values being basically consistent.

Source: Bloomberg, CICC Research Department

Chart: The U.S. bond rate can be decomposed into rate expectations and term premium, with rate expectations further decomposed into real rate expectations and inflation expectations.

Source: Federal Reserve, CICC Research Department

Chart: The term premium has also stabilized around 0.

Source: Bloomberg, CICC Research Department

► Household Sector: Mortgage rates are highly correlated with the 10-year U.S. bond rate (correlation coefficient of 0.95). If the mortgage rate, currently slightly higher than the rental yield rate, were to fall to parity, it would mean the mortgage rate needs to drop to 6.7%, corresponding to a 10-year U.S. bond rate of 4.2%.

Chart: We calculate that if residential mortgage rates and rental yield rates are at parity, the 10-year U.S. bond rate needs to drop to 4.2%.

Source: Haver, CICC Research Department ► Business Sector: The interest rate on commercial and industrial loans is highly correlated with the 10-year U.S. Treasury bond rate (correlation coefficient of 0.88). If the effective interest rate on business sector loans aligns with the return on invested capital (ROIC), it means that the loan rate needs to fall to 5.9%, corresponding to the 10-year U.S. Treasury bond rate needing to drop to 4.1%.

Chart: We calculated that if the effective interest rate on business sector loans aligns with ROIC, the 10-year U.S. Treasury bond rate needs to decrease to 4.1%.

Data Source: Bloomberg, FDIC, Federal Reserve, CICC Research Department

Furthermore, by normalizing the inverted yield curve to a 4% long-term rate, we calculate the extent of rate cuts needed. Considering that the Fed's rate cuts in this round are not aimed at stimulating the economy but at easing yield pressure and financial risks, if rates fall below the equilibrium position mentioned above, it may actually stimulate economic recovery. Based on this, we estimate that the Fed may need to cut rates by around 100-125 basis points, which is consistent with the Fed's updated dot plot from the June FOMC meeting, forecasting a total of 5 rate cuts of 125 basis points each (1 in 2024, 4 in 2025) (Fed's Restraint is Beneficial for Rate Cuts).

► Resolving the Inverted Yield Curve: The current U.S. bond yield curve still remains at its deepest inversion since the 1980s, and has been maintained for nearly 2 years since mid-2022. Based on the calculation of the 4% long-term bond center mentioned earlier, if there is a need to reverse the current prolonged and extreme yield curve inversion, a rate cut of around 100 basis points is required.

Chart: The current U.S. bond yield curve still remains at its deepest inversion since the 1980s.

Data Source: Bloomberg, Haver, CICC Research Department ► Fixing Bank Net Interest Margin: One of the pressures of financial risk is the continuous inversion of interest spreads leading to damage to the net interest margin of banks. Compared to large banks, small and medium-sized banks with more commercial real estate positions have higher risks (small and medium-sized banks hold commercial real estate loans accounting for 77% of their portfolio), and the net interest margin has declined more significantly after the epidemic. The 10-year U.S. Treasury bond rate leads the bank's net interest margin by about 1 year, with a correlation coefficient of 0.96; the Federal Funds rate leads the bank's financing rate by about half a year, with a correlation coefficient of 0.95. Assuming that the net interest margin of small and medium-sized banks with assets ranging from 1 to 10 billion U.S. dollars drops from the current level of 3.5ppt to the pre-epidemic level of 3.8ppt, and based on the above calculation assuming the 10-year U.S. Treasury bond rate returns to around 4%, it means that the profit asset rate drops from 5.4% to 5.1%, and the financing rate drops from 1.9% to 1.4%. According to the linear relationship between the financing rate and the Federal Funds rate, a drop of around 100bp in the Federal Funds rate is needed to achieve this.

Chart: The extent to which the net interest margin of small and medium-sized banks has declined more significantly compared to large banks after the epidemic

Source: FDIC, CICC Research Department

Chart: Assuming the 10-year U.S. Treasury bond rate returns to around 4%, a drop of around 100bp in the Federal Funds rate can bring the net interest margin back to the pre-epidemic level

Source: Bloomberg, FDIC, CICC Research Department

What insights do assets have? Rate-cut trades can still continue, but it is also close to the end when rate cuts are realized

The above calculation results imply that rate-cut trades are not over yet, but due to the limited extent of rate cuts and market anticipation, rate-cut trades may have passed the halfway mark, which is also the main implication of our outlook for the second half of the year ("Global Market Outlook for the Second Half of 2024: Easing is Already Past the Halfway Mark"), indicating that easing may have passed the halfway mark. This situation, where easing is possible but not by much, and the market is ahead, is very similar to the rate-cut cycles of 1995 and 2019 Therefore, assets benefiting from interest rate cuts can still be traded, but attention should be paid to the range and timely exit, as the realization of interest rate cuts may also signal the end of the interest rate cut trading. According to the relationship between U.S. bond yields and interest rate cut expectations, U.S. bond yields may fluctuate in the range of 4.2% to 4.7% in the short term, corresponding to expectations of three interest rate cuts or no interest rate cuts within the year. After the interest rate cut is realized, rates may fall below 4% due to trading factors, and then gradually rebound due to positive growth expectations. Similar to U.S. bonds, gold follows a similar pattern. Assuming actual interest rates of 1-1.5%, the U.S. dollar at 102-106, the fair value range for gold is $2500 per ounce (Source: Global Market Outlook for the Second Half of 2024: More than Halfway Through Easing).

Chart: U.S. bond trading opportunities are more reflected in the expectation stage before interest rate cuts

Data Source: Bloomberg, FDIC, CICC Research Department

Chart: Excessive interest rate cuts may lead to a rapid decline in rates, which may in turn cause rates to rise due to a rebound in the U.S. economy

Data Source: Bloomberg, CICC Research Department

However, if the market trades excessively and prematurely, stimulating demand improvement, it is also necessary to carefully consider the risk of no interest rate cuts within the year. In this sense, the Federal Reserve's restraint at the June FOMC meeting is still conducive to initiating interest rate cut trading.

After the interest rate cut is realized, gradually shift towards assets benefiting from re-inflation, such as commodities, cyclicals, and financials. However, now is not the time to enter, as commodities and U.S. stocks need to pull back to tighten financial conditions, which is also a necessary condition for interest rate cuts to begin. In other words, "no drop, no buy." However, we are not pessimistic in the long run, as there will be more room for growth after the pullback. With the economic fundamentals difficult to significantly repair in the background, growth still suppresses profits in cyclical sectors, but tech stock earnings are supported by demand from the AI industry, providing support to the overall index. Once interest rates decline and interest rate cut expectations become clear, there may be a 5%-7% upside potential for the year, with the index hovering around 5500 points (Source: [Global Market Outlook for the Second Half of 2024: More than Halfway Through Easing](http://mp.weixin.qq.com/s? Chart: Rate cut trades can still continue, but it is also close to the end when the rate cut is realized

Source: CICC Research Department

[1] The natural interest rate is valued differently under different models. According to the long-term interest rate and PCE estimates in the Fed's dot plot, the natural interest rate is about 0.8% (2.8%-2%), with the New York Fed's LW and HLW models estimating values of 1.2% and 0.7% respectively, and the Richmond Fed's LM model estimating a value of 2.5%. The average is around 1.3%.

[2] https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20231213.pdf

Authors: Liu Gang, Li Yujie, Source: CICC Insight, Original Title: "CICC: A New Approach to Estimating U.S. Treasury Rates" Liu Gang, SAC license number: S0080512030003

Li Yujie, SAC license number: S0080523030005