CICC: Interest Rate Cut Trading Manual
CICC predicts that cooling inflation strengthens the probability of a rate cut in September, with the third quarter being a critical window. The rate-cut cycle is relatively short, and easing measures have passed the halfway mark, transitioning gradually from denominator-benefiting assets to numerator-benefiting assets. With June CPI weakening further, the "door" for a Fed rate cut has opened, raising market expectations for a rate cut in September to 90%. In the third quarter, U.S. inflation is expected to continue to decline, making the period before the election a key window for rate cuts. Rate-cut trades will gradually begin, while the performance of the Chinese market remains uncertain
In June, CPI continued to weaken, combined with Powell's "dovish" remarks [1], opening the "door" to Fed rate cuts. Market expectations for a rate cut in September have also risen to 90%, making a rate cut a "high probability event." We estimate that U.S. inflation will continue to fall in the third quarter, so if nothing unexpected happens during this period, the period before the election will be a key window for rate cuts. After half a year of brewing and "pendulum-like" fluctuations, it seems that a rate cut is finally about to become a reality.
So, do assets trade as expected or as historical experience suggests? For example, many people worry that markets tend to fall during rate cut cycles based on historical experience, but this is actually a direct copy without distinguishing the underlying reasons. Also, is the start of a rate cut the beginning or the end of rate cut trading? Which assets will benefit more, and how will the Chinese market perform? It seems that it's not as linear as it seems. The ECB's "hawkish" rate cut in June provides a different insight ("ECB Rate Cut: A Different Insight"). We will address these questions in this article.
Abstract
Monetary Policy Path: Cooling inflation strengthens the probability of a rate cut in September, the third quarter is a key window
The rise in U.S. bond yields in the second quarter tightened financial conditions, causing economic data released since July to weaken, further boosting expectations of a rate cut. This mirrors the situation in the fourth quarter of last year and the first quarter of this year, as we have always pointed out that the less expected a rate cut, the more likely it will happen, and vice versa. The special nature of this cycle is the reason for this. As the financing costs and investment returns of various sectors are very close, a small rate cut can restart the credit cycle and boost demand. This is also why the market's anticipation of a rate cut ahead of time will delay the urgency of the Fed's rate cut ("The Pendulum and 'Endgame' of Rate Cut Trading"). The implied probability of a rate cut in September shown by CME rate futures has risen to 90%, and if nothing unexpected happens (such as a sudden supply shock or excessive rate cuts leading to a loosening of financial conditions and a subsequent improvement in demand), we believe that a rate cut will also become a high probability event. Therefore, rate cut trading may gradually begin.
The third quarter is a key window for the Fed's rate cut, but a rate cut does not mean a significant cut, and the start of a rate cut does not mean that rate cut trading will last long. On one hand, we estimate that the third quarter will see a rapid decline in inflation, providing a window for rate cuts, with a slight uptick in inflation and the start of the sprint period for the election in the fourth quarter. On the other hand, the purpose of this rate cut is not to address economic recession, but to alleviate the restrictive nature of monetary policy and the issue of yield curve inversion, so there is no need for continuous and significant rate cuts ("A New Approach to Estimating U.S. Bond Yields").
"General" Rules of Previous Rate Cut Cycles: Simple "historical averages" are meaningless, more similar to 1995 and 2019
From a general perspective, we first summarize the frequency and average annual performance of various assets in the month before and after the start of rate cuts, as well as 1 month, 3 months, and 6 months after the start, in the 6 rate cut cycles since the 1990s. Overall, U.S. bonds, gold, and the Shanghai Composite Index performed better before rate cuts, while industrial metals, crude oil, the Hang Seng Index, the Nasdaq, and the U.S. dollar performed better after rate cuts than before;The flexibility of the Hong Kong stock market is greater than that of the A-share market; at the industry level, defensive and growth sectors led the way before the rate cut, and continued to do so after the rate cut. However, 3-6 months after the rate cut, the performance of cyclical sectors showed some recovery.
However, the biggest problem with simply averaging historical experiences is that it masks the differences between each time. Rate cuts are a result, not a cause, so when assessing their impact on assets, it is more important to start from the economic environment rather than simply applying historical rate cut experiences. Most rate cuts in history occurred in recession scenarios, while this round is a preemptive rate cut, so there is a fundamental difference in the impact on assets.
Therefore, a more meaningful approach is to find comparable periods. The rate cuts in the current environment are more comparable to 1995 and 2019. In 1995 and 2019, the economy slowed down before the rate cuts but did not enter a recession, achieving a soft landing after a slight rate cut. In terms of assets, gold and US bonds performed better before the rate cut, with narrower gains after the rate cut, gradually transitioning from denominator-driven logic to numerator-driven logic in US stocks and copper. Domestic assets rebounded slightly in the early stages of the rate cut, but the magnitude was limited, relying more on their own fundamentals. For example, in 2019, even with the Fed rate cut, due to the L-shaped recovery of domestic fundamentals, the market mostly showed a range-bound structural market.
The "unusual" pattern of this cycle: the rate cut cycle is relatively short, easing is already halfway through, transitioning from denominator-benefiting assets to numerator-benefiting assets
This round of rate cuts is more similar to 2019. We have summarized the following three characteristics: 1) Limited rate cuts under an economic soft landing. Due to decent economic fundamentals, a slight rate cut after the rate cut leads to a fall in interest rates, easing overall financial conditions, which may activate private sector investment and consumer demand, thus not requiring continuous large rate cuts. We estimate that this round of easing monetary policy and addressing the issue of inverted yield curve only requires a 100bp rate cut ("A New Approach to Calculating US Bond Yields"). This also means that the expectation for the PBOC to open up a large rate cut space after external pressures ease still needs to be observed. 2) Rate cut trades have already "run ahead". The current market's expectations for the number of rate cuts are still higher than the guidance given by the Fed's dot plot and the amount needed for monetary policy to return to neutral, as calculated by us. Gold is included the most, while US bonds are included less. 3) High trading concentration, faster rotation. Reviewing the trading activities since the beginning of the year, such as the early rise of Bitcoin and the Nasdaq, followed by the Japanese stocks, gold, copper, and Hong Kong stock markets, which then switched back to US tech leaders. The result of fund clustering is that some trades are more concentrated, making it easier to see short-term declines caused by "rotation", such as the shift from leading US tech stocks to small-cap stocks after the CPI announcement, and the style shift in the Chinese market from gold and metals to banks and real estate.
Therefore, considering the characteristics of this round of rate cuts being relatively short, the market running ahead, and high trading concentration, for this round of rate cut trades, we suggest taking a moderate step ahead. 1) Assets that benefit more from the denominator logic early on (such as US bonds, gold, small-cap growth, and some growth stocks in the Hong Kong market) may have greater flexibility, but may gradually end after the rate cut, especially if there is no fundamental support. 2) Later on, it should gradually shift to assets that can improve the fundamentals through rate cuts (such as post-rate cut US stocks, tech leaders, copper, or sectors benefiting from domestic rate cuts)Specifically,
► Overseas Assets: Transition from loose trading to re-inflation trading. Initially, there is great elasticity in the denominator, but after the rate cut is implemented, the focus gradually shifts to assets benefiting from the numerator. In terms of pace, the initial main theme is loose trading, but it is important to "know when to stop" and "fight and retreat." After the rate cut is implemented, the transition is made to re-inflation trading. Assets benefiting from the loose rate cut can still be involved, such as US Treasuries, gold, etc., but due to asset front-running, the loose phase is already halfway through. The time of the rate cut implementation may also mark the end of the rate cut trading, gradually transitioning to assets benefiting from re-inflation, such as bulk commodities like copper and oil, and cyclical sectors in the US stock market.
In terms of assets, focus on assets benefiting from both the numerator and denominator during the rate cut, and be cautious with assets that only benefit from the denominator. Generally, after the rate cut, the sequence follows leading technology stocks (profitable numerator) → small-cap growth stocks (liquidity denominator) → cyclical financials (numerator recovery after rate cut). However, considering the situations of "front-running" and "rotation," and the fact that there won't be many rate cuts in this round, assets that only benefit from the improved liquidity of the denominator but lack other benefit logics need to "fight and retreat," such as US Treasuries, gold, and small-cap stocks lacking profit support. On the contrary, assets that solve both numerator and denominator issues during the rate cut will perform better. After the rate cut, assets benefiting from the demand uplift brought by the decline in financing costs, thereby improving the profitability of the numerator, will have relatively higher allocation value. For example, top technology stocks compared to small-cap stocks lacking profit support, cyclical sectors like finance and real estate, and copper compared to gold.
► Chinese Assets: Initially, growth stocks may benefit, but relying solely on external environment has limitations. It is still advisable to focus on structural opportunities in the future. On one hand, the rate cut by the Federal Reserve will still provide some support in terms of liquidity. We estimate that if the 10-year US Treasury yield falls to 3.8-4% (corresponding to 4-5 rate cuts in the next year), with risk appetite and profits remaining unchanged, the Hang Seng Index is expected to approach 18,500-19,000 points. If risk appetite further recovers to the early 2023 level, the market is expected to reach around 20,500-21,000 points, similar logic applies to the Shanghai Composite Index. On the other hand, fundamentals still remain the main influencing factor for the domestic market performance. In the fourth quarter of last year, as the 10-year US Treasury yield fell by about 0.7 percentage points to 3.9% from 4.6%, the domestic market still declined. Looking ahead, whether the market upside space can be opened depends on the recovery of domestic fundamentals and policy catalysts. On the positive side, the rate cut by the Federal Reserve is expected to open up room for rate cuts domestically, helping to alleviate the still relatively high financing costs.
In terms of sector allocation, during short-term rate cut trading, attention can be paid to assets benefiting from liquidity. Historical experience shows that Hong Kong stocks outperform A-shares, and growth sectors such as semiconductors, automobiles (including new energy), media and entertainment, software, biotechnology, etc., may have higher elasticity. Conversely, high dividend-yielding stocks may underperform in the short term, but this is also a normal phenomenon. However, short-term liquidity-driven movements do not change the overall allocation pattern. We believe that unless there is a significant fiscal stimulus to offset private credit contraction, the market will still present a structural market under a volatile pattern, focusing on three directions: overall return decline (stable returns from high dividends and high buybacks, i.e., "cash cows" with ample cash flow), partial leverage increase (policy support and still prosperous technology growth), partial price increase (natural monopoly sectors, upstream and utilities)Table of Contents
Main Text
Monetary Policy Path: Probability of Rate Cut in September Rising, Third Quarter is a Key Window
With further weakening of the June CPI and Powell's "dovish" remarks, the "door" to a rate cut by the Federal Reserve has been opened, with market expectations of a rate cut in September rising to 90%. After half a year of brewing and "pendulum-like" fluctuations, a rate cut seems to finally become a reality. However, will assets trade as expected or as per historical experience? For example, many people may cite historical experience to worry that markets often decline during rate cut cycles, but this is actually a direct copy without distinguishing the underlying reasons. Moreover, is the start of a rate cut the beginning or the end of rate cut trading? Which assets will benefit more, and how will the Chinese market perform? It seems that it's not as linearly simple as it seems. The "hawkish" rate cut by the ECB in June provides a different insight ("ECB Rate Cut: A Different Insight"). We will address these questions in this article.
In fact, not only the CPI has been declining recently, but economic data released since July has also shown weakening trends. The inflation indicators that the Federal Reserve is monitoring have fallen for three consecutive months. The overall CPI (2.97% YoY vs. expected 3.1%) and core CPI (3.27% YoY vs. expected 3.4%) for June, as announced last week, were significantly lower than market expectations. The inflation structure has improved significantly, with rents that were high in the previous months showing a significant decline MoM, and medical and transportation services also cooling down. In addition, recent data on PMI, unemployment rate, and other indicators have shown weakness, leading to an increase in market expectations of a rate cut by the Federal Reserve in September.
Various assets have gradually priced in the expectations of a rate cut. The implied probability of a rate cut in September shown by CME interest rate futures has risen to 96%. The 10-year US Treasury yield has declined from around 4.5% in early July to the current 4.2%, the US dollar has weakened from 106 in early July to 104 currently, gold has risen from around $2300 per ounce in early July to surpass $2400 per ounce, and although US stocks showed a flat performance on the day of the inflation data release, they have recorded an overall increase since July.
The key factor determining whether the Federal Reserve will cut rates remains the downward trend in inflation. We estimate that inflation in the third quarter may quickly fall. Inflation may benefit from the cooling of commodity inflation and gradual decline in service inflation, with the overall YoY CPI possibly reaching a low point of 2.83% in August and core CPI reaching a low point of 3.23% in November. However, by the end of the year, whether it's simply base effects, rate cut expectations leading to a rebound in inflation, or inflationary policies due to the election, there may be some tail risks for inflation (we estimate PCE to fall to around 2.5% in August)At the end of the year, under the influence of the inflation tail effect, it rose to 2.8%.
Therefore, the third quarter is the main window for the Fed to cut interest rates. However, the difference from the current market expectations is that, under the condition of good fundamentals, we believe that the magnitude and frequency of interest rate cuts within the year may be limited ("A New Approach to Calculating US Treasury Yields"). On the one hand, we have emphasized many times before that the Fed does not need inflation to fall to 2% to cut interest rates, but rather needs to see a trend of inflation falling to 2%. Fed Chairman Powell also stated on Wednesday in his testimony to the U.S. House of Representatives that "interest rate cuts do not need to wait for inflation to fall to 2%" [2]. On the other hand, reviewing the Fed's previous interest rate cuts, not all of them were in response to economic recession; there were also preventive interest rate cuts to ease financial risks. Therefore, in a context where demand still shows resilience, the Fed only needs to wait for an appropriate inflation window for a small interest rate cut to alleviate the restrictive monetary policy and the issue of an inverted yield curve, without the need for consecutive large interest rate cuts.
If it is a less common situation of a small preventive interest rate cut, how should we position ourselves for this round of easing trades? In this report, we review the macro environment and asset performance of interest rate cut cycles since the 1990s. Due to the diverse backgrounds of interest rate cuts and the fact that multiple rounds of interest rate cuts involve consecutive large cuts in response to economic recession, the significant difference from the small interest rate cuts under the current economic soft landing means that historical experience cannot be simply averaged, and the current situation may be more similar to 1995 and 2019. Combining historical experience with the characteristics of this round, we have summarized a strategic guide for interest rate cut trades applicable to the current situation for investors to refer to.
Chart: In June, inflation significantly cooled down, with overall CPI falling to 2.97% year-on-year
Source: CME, CICC Research Department
Chart: Current market expectations show a probability of over 90% for an interest rate cut in September
Source: Bloomberg, CICC Research Department, as of July 13, 2024
Chart: The financial conditions index started to rise from mid-June, and by July 1, the interval high point had risen by 10 basis points, suppressing demand and growth in June![] (https://mmbiz-qpic.wallstcn.com/sz_mmbiz_png/fzHRVN3sYs8NgtCsYKblviaoEDZ0xa0sHMgYRGxVzD0fCUOB5icaTTUevT5C5ztGa1dBXQHQVN061h0tf1LR5bdQ/640?wx_fmt=png&from=appmsg)
Data Source: Bloomberg, CICC Research Department
Chart: We calculate that the third quarter is a period of rapid inflation decline and also a window for the Fed to cut interest rates.
![] (https://mmbiz-qpic.wallstcn.com/sz_mmbiz_png/fzHRVN3sYs8NgtCsYKblviaoEDZ0xa0sHB7NN9xve8NxGraOp0TTM5PA6NeoZ8hTNrp44MOibe40nwfwkDXFOdCA/640?wx_fmt=png&from=appmsg)
Data Source: Haver, Bloomberg, CICC Research Department
Chart: Considering interest rate differentials and financial risks, the Fed may only need to cut interest rates by about 100 basis points, from 5.3% to 4.3%.
![] (https://mmbiz-qpic.wallstcn.com/sz_mmbiz_png/fzHRVN3sYs8NgtCsYKblviaoEDZ0xa0sHNAeb1LLWI8FOicdTiamYluhHKaJpelwRDoCiba7QbUoeJuF0xGOKa8w0w/640?wx_fmt=png&from=appmsg)
Data Source: Bloomberg, CICC Research Department
Chart: US bond yields have fallen since the end of October last year.
![] (https://mmbiz-qpic.wallstcn.com/sz_mmbiz_png/fzHRVN3sYs8NgtCsYKblviaoEDZ0xa0sHVXTXyRIWFAib3zmuCta1jwyFKgWuBovnic9FBdnvwgDpJCficM84DnyMA/640?wx_fmt=png&from=appmsg)
Data Source: Bloomberg, CICC Research Department
Historical "normal" patterns: The significance of "historical averages" is limited, and the current situation is more similar to 1995 and 2019.
Comparable periods: 1995 and 2019, the macro background is more like 2019.
Overseas markets: Slight rate cuts for a soft landing, with US bonds and gold outperforming before the rate cut, then switching to US stocks and copper.In the second half of 2024, the baseline assumption for the U.S. economy is a moderate slowdown, which is comparable to 1995 and 2019 in terms of previous rate cuts.
► In terms of the macro environment, before the rate cuts in 1995 and 2019, the economy slowed down but did not enter a recession, and after a slight rate cut, it smoothly landed. In both cases, there were three small rate cuts totaling 75 basis points while the economy was not in a recession. During the rate cut phase, the U.S. unemployment rate remained stable, and the PMI clearly stopped its downward trend after the rate cuts. Before the end of the rate hike cycle and the start of the rate cut cycle, the decline in U.S. bond yields drove a significant rebound in real estate sales. However, after the actual rate cut, U.S. bond yields began to rise, and the rate of recovery in real estate sales slowed marginally. The U.S. CPI basically confirmed an upward trend during the rate cut cycle.
► In terms of asset performance, based on these two historical experiences, gold and U.S. bonds performed better before the rate cuts, and their gains may narrow after the rate cuts. After several rate cuts, as growth gradually improves under a soft landing, the opportunities for long-term U.S. bonds and gold diminish as demand improves, gradually shifting from the denominator logic to the numerator logic of U.S. stocks and copper.
In terms of sectors and industries, rate-sensitive sectors such as technology and media benefited relatively before the rate cuts, and after the rate cuts, industries with profit recovery on the numerator side, such as real estate, financial services, banks, and post-real estate cycle automotive sectors, outperformed relatively.
Chart: The Fed cuts rates early to prevent excessive tightening risks, as in 1995 and 2019, when the Fed made a small 25 basis point rate cut while the economy was not in a recession.
资料来源：Bloomberg，CICC Research Department
Chart: Technology and media industries benefited from rate cut expectations before the rate cuts, while automotive and parts industries benefited from demand improvement after the rate cuts.
资料来源：Bloomberg，CICC Research Department
Chart: Defensive sectors performed relatively stable before and after rate cuts.
资料来源：Bloomberg，CICC Research DepartmentData source: Bloomberg, CICC Research Department
Chart: Real estate, banking, and financial services industries significantly benefit from demand improvement after interest rate cuts
Data source: Bloomberg, CICC Research Department
Chart: Raw materials and capital goods industries perform relatively well after interest rate cuts
Data source: Bloomberg, CICC Research Department
Chinese Market: Structural market trends under stable leverage in comparison to 2019
In the early stages of interest rate cuts, most Hong Kong stocks outperform A-shares, with growth sectors benefiting first. However, this impact is short-lived, and overall market performance is more influenced by domestic fundamentals. Taking 2019 as a similar example, even with the Fed cutting interest rates, the market in China, under weak recovery, showed a volatile L-shaped trend, contrasting sharply with the V-shaped rebound in 2017 when the Fed raised rates but China experienced strong growth. This indicates that under the mismatched cycles between China and the US, Fed policy cannot determine domestic market trends. Compared to external liquidity changes, the Chinese market trend relies more on domestic fundamentals. Furthermore, in the same interest rate cut cycle, different fundamental characteristics correspond to different asset performances. For example, in 2007-2008 and 2019, both in a Fed interest rate cut cycle, the Chinese market showed initial strength followed by rapid pullback in 2007-2008 due to overheating economy and high inflation, while in 2019, under partial deleveraging, it presented a structural market trend of index volatility and consolidation.
Therefore, with the greater influence of domestic fundamentals on the Chinese market, it is difficult to draw general conclusions from reviewing past interest rate cut cycles. It is more crucial to find comparable periods. As mentioned above, the current external environment can be compared to 2019, with the US economy experiencing a soft landing or no landing, limited Fed interest rate cuts, and some similarities in the domestic environment to 2019► Macro Environment: The external Federal Reserve has stopped raising interest rates and is expected to cut rates, while domestic growth is weakly recovering. On one hand, the Federal Reserve stopped cutting interest rates at the beginning of 2019 and made its first rate cut in July 2019. This round of the Federal Reserve monetary cycle is also expected to enter the tightening phase in mid-2023, with the market currently expecting a high probability of rate cuts starting in September. On the other hand, both the current internal growth momentum and internal economic growth in 2019 are insufficient. Without a significant increase in leverage overall, the economic environment is showing a weak recovery and stable leverage situation.
► Fund Flows: Foreign capital continues to flow out, and long-term foreign capital inflows require fundamental support. From 2018 to 2020, active foreign capital continued to flow out of the Chinese stock market, with a total outflow of approximately $20.3 billion. Starting in July 2019, with the improvement of external liquidity due to rate cuts, foreign capital did not return in large numbers. It was not until September 2020, after the fundamentals improved and profits significantly increased, that foreign capital began to return. Currently, active foreign capital has been flowing out of the Chinese stock market for 61 consecutive weeks, with a total outflow of over $30 billion since March 2023. With overseas funds generally underweighting Chinese stocks, inflows still require fundamental support, and loose external liquidity is not the main factor driving significant foreign capital inflows.
► Asset Performance: Under the willingness of stable leverage policies, it presents a structural market under a volatile pattern. Similar to 2019, in the macro environment where leverage is not significantly increased overall, the possibility of an index-level market is not high. However, under the willingness of stable leverage policies, the market is not likely to decline unilaterally like during the "deleveraging" period, but rather presents a structural market under a volatile pattern.
In terms of sectors, before and after the rate cuts in 2019, the growth sectors benefited from the improvement in liquidity, but more as a structural market under partial leverage, which is also the case currently. Against the backdrop of the normalization of Sino-US trade frictions in 2019, domestic substitution emerged, with the growth sectors represented by high-end manufacturing strengthening, the semiconductor and electronics sectors leading the gains, and the new energy sector strengthening since the end of 2019. The combination of dividends and growth in 2022 has been effective, and the current direction of allocation can be further summarized as a decline in overall returns, partial leverage, and partial price increases, also representing a structural market under a volatile pattern.
Charts: The Federal Reserve's monetary policy is not the dominant factor in the domestic market performance, with greater influence from domestic fundamentals.
Source: Bloomberg, CICC Research Department
Charts: Different fundamental characteristics during rate-cutting cycles correspond to different asset performances.
 Research Department
Chart: Defensive sectors' performance relatively stable before and after interest rate cuts
Source: Bloomberg, China International Capital Corporation (CICC) Research Department
Chart: Financial and real estate sectors may rise if fundamentals improve in the later stage after interest rate cuts
Source: Bloomberg, China International Capital Corporation (CICC) Research Department
Chart: Cyclical sectors tend to decline first and then rise after interest rate cuts
The "Unusual" Pattern of This Round: Short Interest Cycle, More Than Halfway Through Easing
With comprehensive cooling of inflation in June, a rate cut in September became a "high probability event." However, on the day when inflation data was announced, the Nasdaq 100, which should have benefited from the rate cut, fell by 2.2%, while the Russell 2000 small caps surged by 3.6%. Chinese A-share and H-share banks and real estate stocks rose sharply, while precious metals and non-ferrous metals fell significantly. This once again illustrates the uniqueness of this round of rate cut trading, which cannot be simply based on historical norms but must be considered in the current environment and circumstances. Even compared to the more similar environment of 2019, there are some unique aspects to this round. By reviewing the experience of 2019 and combining it with the heterogeneous characteristics of this round, we summarize the following trading strategies for investors to consider:
Characteristics of This Round: Slight preventive rate cuts, clear asset "sprints" and "rotations"
Characteristic 1: Limited scope of preventive rate cuts
A soft landing of the U.S. economy in the second half of 2024 is a high probability event, with the baseline scenario being a moderate slowdown in growth. The feature of the current U.S. economic cycle is a "rolling" slowdown and repair of various sectors, with financial conditions in the U.S. currently in a range that effectively restrains private sector demand. Subsequent consumption, real estate, and investment may still see "one down, two up"The consumption is unlikely to decelerate significantly, coupled with the recovery of real estate and investment cycles already underway. Compared to the slowdown at the end of last year, the main support comes from the resilience of consumption and the drive of AI investment. We estimate that the US GDP will not decline significantly on a quarter-on-quarter basis this year, with a soft landing as the baseline scenario. Under a slower rate of interest rate cuts compared to 2019, consumption will gradually slow down, real estate recovery will be weaker than in 2019, and the intensity and sustainability of fixed asset investment will benefit from the AI industry trend being stronger than in 2019 ("Global Market Outlook for the Second Half of 2024: Easing is halfway there").
The fundamentals of the US economy are not bad, so cutting interest rates does not mean cutting by a large margin. Due to the good fundamentals, demand may quickly improve after the rate cut, as seen from the end of last year to the first quarter of this year. The expectation of rate cuts drove the US bond yields down rapidly from a high of 5% to 3.8%, loosening overall financial conditions and activating private sector investment and consumer demand. For example, residential real estate investment warmed up, with the 30-year mortgage rate dropping from 7.8% to 6.6% over three consecutive months, and the housing sales turnover ratio rising from a low of 4.52 million units in November to 5.02 million units over three months. Corporate bond issuances also increased, with a bond issuance scale of $625.1 billion in the first quarter, up 135% and 37.9% compared to the fourth quarter of last year and the same period last year, respectively ("The Pendulum of Rate Cut Trades and the 'Endgame'"). We estimate that this round of easing monetary policy only requires a 100 basis point rate cut to address the restrictive nature of the policy and the issue of yield curve inversion ("A New Approach to Estimating US Bond Yields"), without the need for consecutive large rate cuts.
A smaller and slower rate cut by the Federal Reserve also means that the expectation of a significant rate cut space by the domestic central bank after external pressures ease still needs to be observed. At the same time, the increasing uncertainty in geopolitical situations and limited boost from overseas liquidity easing on fund inflows and domestic market performance mean that the market trend reversal increasingly relies on domestic fundamentals and policy progress.
Chart: The characteristic of the current US economic cycle is the "rolling" slowdown and recovery of various sectors.
Source: CICC Research Department
Characteristic Two: Trading "front-running," especially in traditional beneficiary assets such as US bonds and gold
The market is relatively optimistic about the expectations of rate cuts in this round, leading to frequent "reversals." Since the last rate hike in July 2023, the market has been waiting for the first rate cut of this round by the Federal Reserve for over a year, especially since the announcement of the end of the rate hike cycle at the November meeting last year. Market expectations of rate cuts have boosted trading in related beneficiary assets such as US bonds and gold. The current market's expectations for the number of rate cuts are still higher than the guidance given by the Federal Reserve's dot plot and the magnitude required for monetary policy to return to neutral as estimated by us ("A New Approach to Estimating US Bond Yields")We calculate that gold is priced in the most, while short-term bonds are priced in less. In the report "How much rate cut expectation is priced into current asset prices?", we introduced the Asset Pricing Monetary Policy Expectations Model, and conducted multiple optimizations in reports such as "What rate hike expectations are priced into current assets?". The core idea of this model is to strip out interest rate factors from various asset prices, ultimately deriving the implied U.S. Treasury bond rate from asset prices, and thus calculating the policy expectations priced into various assets. According to our calculations, data as of July 12th shows that gold implies a 105bp rate cut, interest rate futures imply an 86bp rate cut, which is roughly in line with U.S. stocks (86bp), while the rate cut expectation priced into short-term bonds is relatively lower (31bp), and long-term bond rates have basically returned to the levels before Fed Chair Powell's dovish remarks in December. From the current rate cut frequency and future space priced into various assets, short-term bonds appear more attractive.
However, this type of trading faces the constraint of financial condition reflexivity, as the repeated rate cut expectations since 2024 have been influenced by this, and the market "front-running" may weaken the basis of trading. 1) A loosening of financial conditions may further boost demand. We calculate that whether it is the mortgage rate relative to rental yield, or the corporate loan rate relative to ROIC, the degree to which financing costs suppress investment returns is just right. A loosening of financial conditions may re-activate demand for interest-sensitive sectors such as real estate, thereby raising the risk of re-inflation. 2) We analyze that the policy proposals of both parties' candidates in this year's election, while boosting the U.S. economy, come with a certain degree of inflationary attributes, leading to the possibility of reigniting inflation expectations after the election, which may in turn prevent the Fed's rate cuts from lasting too long ("How the U.S. election affects policy and assets").
Chart: Excessive rate cut trades leading to too rapid decline in rates may instead cause a rebound in the U.S. economy and lead to rate hikes
资料来源：Bloomberg, CICC Research Department
Chart: Rate cut trades can still continue, but when rate cuts are realized, it is also close to the end
资料来源：CICC Research DepartmentChart: We calculate that gold accounts for the most, short-term bonds account for the September rate cut, and long-term bonds account for less.
Source: Bloomberg, FactSet, CICC Research Department
Chart: Although this round of Fed rate hikes is fast and large, the actual increase in financing costs just barely suppresses the investment return rate.
Source: Bloomberg, Haver, CICC Research Department
Feature Three: Some trading concentration is high, such as US tech leaders, which can easily cause "rotation"
Since the beginning of this year, the "wind" of asset rotation has accelerated, and each round of strong assets is accompanied by overheated emotions and crowded trades, which in turn accelerates the rotation. Reviewing several rounds of trading since the beginning of this year, first, the liquidity expansion at the beginning of the year drove Bitcoin and the Nasdaq to soar, then it shifted to Japanese stocks, gold, and copper leading the way, then to the Hong Kong stock market, and then back to the US tech leaders. Although the fundamental logic behind the "wind" of assets is different, the highly similar characteristics of overheated emotions and crowded trades leading to a high point of several rounds of strong assets correspond to sustained overbought overheated emotions.
The result of fund clustering is that some trades are more concentrated, making it easy to see a short-term decline caused by "rotation," such as the "big to small" shift of US tech stocks to small-cap stocks after the CPI announcement, and the style shift from gold and non-ferrous metals in the Chinese market to banks and real estate.
Regardless of the reason for concentrated trading, the result pointed to by the emotional high of fund clustering is that a single logic is difficult to support a sustained rise in assets, so the speed of style shifts and asset rotations accelerates, making it difficult to grasp the "wind," which is also one of the characteristics to consider when benefiting from loose trading assets in this round of rate cuts.
Chart: The asset "wind" that has been rotating continuously since the beginning of this year, from Bitcoin to Japanese stocks, to gold and copper, then to Hong Kong stocks, all accompanied by overheated emotions.
Source: Bloomberg, CICC Research Department
Trading Strategy: Moderately advance half a step, initially focusing on denominator assets with greater flexibility, but gradually shifting towards numerator assets
Therefore, combining the characteristics of the current short interest rate cut cycle, market anticipation, and concentrated trading, for this round of interest rate cuts, we suggest moderately advancing half a step. 1) Initially, assets that purely or more benefit from denominator logic have greater flexibility (typical examples include US bonds, gold, small-cap growth stocks, and some growth stocks in the Hong Kong stock market), but may gradually end after the interest rate cut is realized, especially if there is no fundamental support, it cannot sustain for long. 2) Later on, the focus should gradually shift towards assets that can improve the fundamentals of the numerator after the interest rate cut (typical examples include US stocks in the later cycle, leading technology stocks, copper, or sectors benefiting from domestic interest rate cuts).
Overseas Assets: From loose trading to reflation trading, gradually switch after interest rate cut realization
From the perspective of trading rhythm, the main theme shifts to loose trading, but should be done "in moderation". Market anticipation and the reflexivity of financial conditions may lead the main theme to switch relatively quickly to reflation trading. Just like the situation from the end of last year to the first quarter of this year, the heating up of interest rate cut expectations pushed US bond yields from a high of 5% to a rapid decline to 3.8%, driving overall financial conditions to loosen, activating private sector investment and consumer demand ("The Pendulum of Interest Rate Cut Trading and the 'End Game'"), and shifting from US bonds and gold driven by loose trading to copper and oil favored by reflation trading.
Assets benefiting from the loose interest rate environment can still be traded, but attention should be paid to the range and timely exit, as interest rate cuts may signal the end of the interest rate cut trading. Based on the relationship between US bond yields and interest rate cut expectations, US 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 within the year and no interest rate cuts within the year. After the interest rate cut realization, yields may fall below 4% due to trading factors, and then gradually rebound due to positive growth expectations, gradually shifting towards assets benefiting from reflation, such as copper and oil, as well as major commodity resources in the US stock cycle sectors. Similar to US bonds, this applies to gold as well. Assuming real interest rates of 1-1.5%, and the US dollar at 102-106, we calculate the fair value of gold to be $2500 per ounce ("Global Market Outlook for the Second Half of 2024: More than halfway through the loose phase").
In asset selection, focus on assets that benefit from both the numerator and denominator after the interest rate cut, and be cautious with assets that only benefit from the denominator. Generally, after an interest rate cut, the sequence follows leading technology stocks (with earnings in the numerator) → small-cap growth stocks (liquidity in the denominator) → cyclical financials (repairing after the interest rate cut in the numerator). However, considering the "anticipation" and "rotation" scenarios, as well as the limited number of interest rate cuts in this round, assets that only benefit from the improved liquidity of the denominator due to the interest rate cut but lack other benefit logics need to "fight and retreat", such as US bonds, gold, and small-cap stocks lacking profit support. This is also the reason why we proposed that the loose phase is more than halfway through in the outlook for the second half of 2024 ("Global Market Outlook for the Second Half of 2024: More than halfway through the loose phase").
On the contrary, assets that address both numerator and denominator issues after the interest rate cut will perform better. After the interest rate cut, assets that benefit from the demand uplift brought by the decline in financing costs, thereby improving the earnings on the numerator side, will have relatively higher value in allocationFor example, in comparison to small-cap stocks lacking profit support, cyclical sectors such as financials and real estate, and copper in comparison to gold.
Chart: From a trading strategy and pace perspective, more than half of the current trades are loose, with inflation trades yet to be completed.
Source: Bloomberg, FactSet, CICC Research Department
Chart: From a pace perspective, more opportunities for U.S. bond trades are reflected in the pre-rate cut expectations stage.
Source: Bloomberg, CICC Research Department
Chart: Historical experience shows that U.S. bond gains are more evident from the pre-rate cut to within 3 months after the rate cut.
Source: Bloomberg, CICC Research Department
Chart: Gold performs better near rate cuts, with gains narrowing after the rate cut.
Source: Bloomberg, CICC Research Department
Chart: U.S. stocks show more significant gains in the later stages after rate cuts.
, with risk appetite and earnings remaining stable, the Hang Seng Index is expected to approach 18,500-19,000 points. If risk appetite further recovers to early last year's levels, the market could reach around 20,500-21,000 points. The Shanghai Composite Index is also expected to benefit from the Fed rate cut as it provides policy adjustment space for the domestic central bank. However, on the other hand, fundamentals remain the main influencing factor for the domestic market performance. In the fourth quarter of last year, while the 10-year U.S. Treasury yield decreased by about 0.7 percentage points to 3.9%, the Shanghai Composite Index fell by 4.4% and the Hang Seng Index fell by 4.3%, once again confirming that external liquidity improvement is difficult to reverse the market situation in a weak domestic growth environment. Additionally, due to the existence of front-running in rate cut trades and the limited expected magnitude of the Fed rate cut, the impact of this round of Fed rate cuts on the Chinese market may be relatively small, with domestic fundamentals and policy progress continuing to lead the market direction.
Looking ahead, whether the market upside space can be opened still depends on the recovery of domestic fundamentals and policy catalysts. In the second half of the year, our outlook "Hong Kong Stock Market 2024 Second Half Outlook: Seeing Clearly in Confusion" emphasizes that the root cause of the market weakness and growth pressure issues is credit contraction, especially as the current fiscal policy strength still needs to be strengthened in terms of speed, otherwise it is not enough to offset the faster private credit contraction. To address this issue, leveraging up fiscal policy and reducing financing costs are indispensable measures, and both scale and speed are equally important. We estimate that an additional fiscal stimulus of 4-5 trillion yuan and a 75-100 basis points reduction in the 5-year LPR could be effective, but achieving this scale is somewhat challenging, and the later the action is taken, the larger the scale needed. Current export front-running may lead to a weakening of export margins in the second half of the year. Historically, weak exports often correspond to stronger policy measures, but expecting strong policy stimulus is not realistic. Various internal and external constraints make it difficult for policies to be presented in a straightforward manner, whether learning from past experiences or leaving room for uncertainty in geopolitics and policies after the U.S. election, policy measures may be more reactive, and timing may be more lagging rather than proactive.
In summary, in the short term under rate cut trading, attention can be focused on liquidity-benefiting assets, with historical experience showing that Hong Kong stocks outperform A-shares. The Fed rate cut in the short term still has the potential to improve denominator liquidity, and Hong Kong stocks, which are more sensitive to external liquidity, may perform better than A-shares. Growth stocks may benefit more, such as semiconductors, automobiles (including new energy), media entertainment, software, biotechnology, etc., while high dividend stocks may underperform in the short term, but this is also a normal phenomenon. This may be more evident before and after the rate cut opens, but the duration will not be very long. Short-term liquidity drive does not change the overall allocation pattern. We believe that unless there is a significant fiscal stimulus to offset private credit contraction, the market will still present a structural market under a volatile patternUnder this background, we suggest focusing on three main directions: overall return decline (high dividends and high repurchases of stable returns, i.e. "cash cows" with abundant cash flow), partial leverage increase (policy support and still vibrant technological growth), and partial price increase (natural monopoly sectors, upstream and utilities). Firstly, high dividends (traditional telecommunications, energy, utilities, and some internet consumer sectors that are stable "cash cows") as one end of the "dumbbell" have long-term allocation value in the context of overall return decline. Secondly, sectors with policy support or positive economic outlook are still expected to benefit from favorable boosts and show greater elasticity. The upcoming Third Plenum is also expected to introduce further supportive policies for new productive forces. Therefore, we are optimistic about certain sectors with positive economic outlook, such as electrical equipment, technology hardware, semiconductors, software and services, which still have potential for leverage and growth. Thirdly, compared to industries where declining prices harm profit margins, sectors with price increases such as natural gas, non-ferrous metals, utilities, and even some essential consumer goods, can protect profit margins and enjoy greater bargaining power.
Chart: If the 10-year US Treasury yield falls to 3.8-4%, risk appetite remains unchanged, and profits are maintained, the Hang Seng Index is expected to approach 18,500-19,000 points.
Data Source: Wind, Bloomberg, CICC Research Department
Chart: If risk appetite further recovers to the level at the beginning of last year, the market is expected to further rise to around 20,500-21,000 points.
Data Source: Wind, Bloomberg, CICC Research Department
Chart: After an interest rate cut, the frequency of Hong Kong stock market rising in the following 1-3 months exceeds 50%.
Source: Wind, CICC Research Department
Chart: Sectors with longer durations such as semiconductors, automobiles (including new energy), media and entertainment, software, etc., may be the first to benefit.
Source: Wind, Bloomberg, CICC Research Department
Chart: The benchmark situation still maintains a "dumbbell" configuration.
Note: The industries highlighted in red have performed well this year, using market consensus data.
Source: Wind, CICC Research Department
[1] https://wallstreetcn.com/articles/3719280
[2] https://wallstreetcn.com/articles/3719280
Authors: Liu Gang S0080512030003, Li Yujie S0080523030005, Wang Zilin S0080123090053, Wang Muyao S0080123060036, Source: CICC Insight, Original Title: "CICC: Rate Cut Trading Manual"