CICC: Rate cut in September is approaching

The overall tone of this meeting is dovish, with several adjustments in wording suggesting an imminent rate cut in September. However, we also emphasize that the ability to cut rates does not mean that there will be many rate cuts, which is the "uniqueness" of this round of rate cuts determined by the current U.S. economic cycle.

Due to this uniqueness, compared to previous rate cuts which followed a similar impact path, the main difference this time is in the pace, which may be faster and more proactive. Failure to understand this may lead to trading "against the trend." A preventive rate cut for a soft landing implies that this switch may happen earlier compared to other rate cut cycles, which is why we emphasize that "easing is already halfway through." In comparable historical stages such as the three rate cuts totaling 75 basis points in 1995 and 2019, after the rate cuts, U.S. bond rates and inflation rebounded, leading to a shift towards U.S. stocks and commodities.

With the market expecting a 100% rate cut in September, investors are closely watching how the Federal Reserve will respond at the July FOMC meeting, and whether there will be any variables. After all, the significant swings in rate cut expectations this year have become somewhat expected. Based on the statements from this meeting and Powell's post-meeting press conference, the Federal Reserve has further hinted at a rate cut in September, emphasizing that inflation pressures have eased and highlighting the balance between employment and inflation risks, rather than just inflation risks. All these suggest that if nothing unexpected happens (inflation continues to fall before the September rate cut), a rate cut in September should be a high probability event.

Chart: Before the meeting, CME rate futures implied a close to 100% probability of a rate cut in September.

Meanwhile, faced with such strong rate cut expectations, the market was initially puzzled as assets did not react as expected. Long-term U.S. bond rates remained stable or slightly increased, gold weakened, and U.S. stocks fell sharply, clearly indicating that the impact of this round of rate cuts on assets cannot be analyzed using conventional methods. How to trade after the rate cuts start is also a common concern for investors ("Rate Cut Trading Manual"). Looking at the performance of assets during the FOMC meeting, various assets responded more positively, with long-term U.S. bonds clearly falling, U.S. stocks surging, the U.S. dollar weakening, and gold rising. Combining this meeting's information with future Fed policy paths and asset impacts, we analyze as follows.

Rate Cut Path: Hinting at a gradual approach to a rate cut in September, denying the possibility of a 50bp cut at once

The overall tone of this meeting is dovish, with several adjustments in wording suggesting an imminent rate cut in September, reflected in: 1) On the inflation issue, it is believed that the trend of inflation falling to 2% is more pronounced ("some further progress toward the 2% inflation goal," removing the original "modest" wording), showing more confidence in the second-quarter inflation decline trend. 2) Acknowledging a cooling labor market ("Job gains have moderated"), which also confirms the rise in unemployment rate data over the past few months3) Believing that the inflation and employment market objectives are moving into better balance (originally stated as move toward), this also means that the Federal Reserve is no longer solely focused on the target of inflation falling to 2%, but is also paying attention to the potential economic risks caused by high interest rates. Powell also stated that he does not believe the job market is a major source of inflation, so he does not expect to see rapid and drastic changes in employment in the short term, implying that "preemptive" rate cuts are not necessary even without a significant deterioration in the job market.

Chart: The Federal Reserve believes that the inflation and employment market objectives are moving into better balance

Previously, Powell emphasized in several speeches that rate cuts do not need to wait until inflation drops to 2% [2], and concerns about the economic pressure caused by cutting rates too late are seen as the prelude to rate cuts. This meeting is the last interest rate decision before September, so the change in the wording of the above statement can also be seen as the Federal Reserve preparing for a rate cut in September. Next, before the September FOMC meeting (September 16-17), there is the Jackson Hole Global Central Bank Annual Meeting (August 22), and based on our preliminary calculations of the non-farm payroll and inflation data for July and August, overall CPI and core CPI are expected to continue to decline year-on-year. The overall CPI year-on-year in July (August 14) and August (September 11) may decrease from 3.3% in June to 2.6% in August, and core CPI year-on-year may decrease from 3.3% in June to 3.1% in August, meeting Powell's conditions of "inflation continuing to decline, and the job market remaining stable." Therefore, it is highly likely that a rate cut in September will occur without any surprises.

Chart: Previously, Powell emphasized that rate cuts do not need to wait until inflation drops to 2%, and the continued downward trend is the key to the Federal Reserve's rate cut.

Chart: Based on our preliminary calculations, overall CPI and core CPI are expected to continue to decline year-on-year.

However, we also emphasize that the ability to cut rates does not mean there will be many rate cuts, which is the "uniqueness" of this round of rate cuts determined by the current U.S. economic cycle. Powell denied the possibility of a 50bp rate cut at this meeting, and the pace of future rate cuts still depends on specific data, leaving flexibility for the subsequent policy path. Since the U.S. economy is not currently facing significant recession risks, the Federal Reserve does not need to cut rates significantly to stimulate the economy, especially considering that the current financing costs do not exert strong pressure on investment returns. We estimate that to address the issue of yield curve inversion and the net interest margin of small and medium-sized banks, the Federal Reserve would need to cut rates by around 100bp (approximately 4 times)The current CME interest rate futures have already factored in 5 rate cuts in the past two years, which is close to the 5 cuts shown in the June Fed "dot plot" and the 4 cuts we calculated.

Chart: The current US Treasury yield curve is still experiencing the deepest inversion since the 1980s. To resolve the inversion, a rate cut of around 100 basis points is needed.

Chart: Assuming the 10-year US Treasury yield returns to around 4%, a decrease of around 100 basis points in the federal funds rate can bring the net interest spread back to pre-pandemic levels.

The "uniqueness" of this rate cut cycle: Non-recessionary rate cuts; rate cuts are possible but not substantial, and asset reactions will be anticipatory

Historical comparisons without distinguishing macroeconomic environments are not only meaningless but also misleading. The pace of rate cuts is more determined by the economic cycle rather than the other way around, otherwise it would be a case of putting the cart before the horse. Economic recession is a sufficient but not necessary condition for rate cuts. The Fed can also cut rates "preventively" before the economy enters a recession, as is the case currently or in 1995 and 2019. Admittedly, the current US economy is in a slowdown phase, which is why the Fed can and needs to cut rates. However, a slowdown should not be equated simplistically with a "recession," as this could lead to overly pessimistic views on risk assets and overly optimistic views on safe-haven assets. It is important to differentiate the degree of slowdown and whether it can be quickly resolved through monetary easing. Pressures that lead to economic recession generally come from: 1) unexpected credit events; 2) sustained financing costs higher than investment returns squeezing the credit cycle. We have not seen these two points, so there is no clear basis or signal for a recession.

Chart: The economy is not in recession, and rate cuts are not recessionary rate cuts.

Therefore, this also determines the "uniqueness" of this rate cut cycle, which is not recessionary in nature. Rate cuts are possible but not substantial. Therefore, we believe that asset reactions will be anticipatory: 1) Background: The economy is not in recession, as indicated by both second-quarter GDP data and June PCE data, showing the resilience of the economy. Therefore, rate cuts are not recessionary. 2) Reason: Precisely because the economy still shows resilience, the less the market expects rate cuts, the greater the room for rate cuts. Conversely, if the market trades substantial rate cuts prematurely, loosening financial conditions, it could lead to economic and inflation rebounds, compressing the space for further rate cuts. 3) Timing: A preventive rate cut for a soft landing requires a "justification," namely that inflation is in a downward trend, which we estimate to be in the third quarter. 4) Frequency: Initiating rate cuts does not mean continuous substantial cuts. We estimate that around 100 basis points can solve the issueDue to the above special characteristics, compared to previous rate cuts which followed a similar impact path, the main difference this time is the pace, which may be faster and more proactive. Failure to understand this point may result in trading "against the trend." The preventive rate cut for a soft landing implies that this transition may occur earlier compared to other rate cut cycles, which is why we emphasize that "loose monetary policy is already halfway through." In comparable historical stages such as the three rate cuts totaling 75 basis points in 1995 and 2019, after the rate cuts, U.S. bond yields and inflation rebounded, leading to a shift towards U.S. stocks and commodities.

Chart: Comparable historical stages such as the three rate cuts totaling 75 basis points in 1995 and 2019

What the market is trading in the near term: Not a recession trade, risk assets falling and safe-haven assets not rising actually help kick off the rate cut in September

Before the rate cut, there was increased volatility in overseas assets, especially with the overall weakness in U.S. stocks, leading some investors to worry about the risk of a recession. We do not entirely agree with the current assessment as a "recession trade," otherwise the trends in gold and U.S. bonds, as well as the steepening of the yield curve, cannot be explained ("Is the current U.S. stock market trading a recession?"). The slowdown in growth and the pullback of risk assets before the rate cut are natural phenomena. Taking 2019 as an example, in the context of an economic soft landing, U.S. stock earnings and valuations also experienced a period of rising earnings and pressure on valuations during the rate hike cycle. When the rate hikes stopped, valuations remained under pressure, as did earnings. After the rate cuts began, valuations recovered first, while earnings remained under pressure in a three-stage process. Against the backdrop of slowing earnings, U.S. stocks experienced pullbacks of 6.8% and 6.1% before the rate cut in May 2019 and the first rate cut in July 2019, respectively.

Chart: On July 24th, gold, copper, and U.S. bonds fell along with U.S. stocks, not a typical "recession trade"

Chart: Pressure on corporate earnings before the rate cut is a relatively normal phenomenon

More important than short-term pullbacks is the recent widespread decline in risk assets and the lack of significant gains in safe-haven assets, which have tightened financial conditions and wealth effects. This tightening actually favors the implementation of the rate cut by the Federal Reserve in September. The recent volatility has caused the financial conditions index to rise from a low of 98.9 on July 16th to 99.3, reaching a new high since June 10th. Tightening financial conditions help to suppress demand and inflation, while the volatility in risk assets also helps to curb wealth effects, which in turn facilitates the implementation of the rate cut by the Federal Reserve in September. At the beginning of the year, excessive trading for a rate cut led to the Federal Reserve postponing the rate cut instead, as the saying goes, "The less expected the rate cut, the more likely it will happen."Chart: The Financial Conditions Index rose from a low of 98.9 on July 16 to 99.3, hitting a new high since June 10.

How to Trade Rate Cuts in the Future? Easing is already halfway through; "Denominator Assets" still benefit before rate cuts are realized, but retreat as needed; shift to "Numerator Assets" after realization

The characteristic of this rate cut cycle is that the U.S. growth is slowing but not in recession, therefore the rate cut cycle and magnitude will not be significant, and the fundamentals may gradually improve after several rate cuts. For this reason, trading solely based on rate cuts (such as U.S. Treasuries, gold, Russell 2000, and small-cap stocks represented by Hong Kong biotechnology) still have room to grow, but should not be overly extrapolated. Instead, when rate cuts are realized, it is time for these trades to "retreat as needed" (from the "Rate Cut Trading Manual"). Conversely, risk assets more influenced by fundamentals on the numerator side are prone to weaken before rate cuts due to the slowdown in fundamentals, but the pullback also provides better entry opportunities, and will also benefit from the improvement in the denominator side after rate cuts.

Chart: Pullbacks provide opportunities to enter rate cut trades, with current easing trades over halfway through and inflation trades not yet completed.

► Before rate cuts are realized, trading solely based on rate cuts (such as U.S. Treasuries, gold, Russell 2000, and small-cap stocks represented by Hong Kong biotechnology) still have room to grow. We estimate the 10-year U.S. Treasury yield centering around 4%, with rate cuts expected to push it down to 3.8%; the center for gold is $2500 per ounce, still with room to grow. Therefore, trading benefiting from the easing rate cuts can still participate, with another wave of upside potential.

Chart: We estimate the 10-year U.S. Treasury yield centering around 4%.

Chart: Rate cut cycles since 1995 show that gold has higher gains during rate cut expectations.

However, due to the relatively short duration of this rate cut cycle and the potential gradual improvement in fundamentals after several rate cuts, these assets should retreat as needed when rate cuts are realized, as indicated in our outlook for the second half of the year "Easing is already halfway through." After rate cuts are realized, long-term U.S. Treasuries may gradually bottom out, and a shift to short-term U.S. Treasuries for steepening the curve trading may be appropriate, while gold may gradually peak.

► Assets that are stable and benefit from rate cuts (such as leading tech stocks, late-cycle U.S. stocks, copper, etc.) also provide better re-entry opportunities after a moderate pullback. Before rate cuts, due to the slowdown in fundamentals and the previous accumulated gains, risk assets naturally face pressure to pull back, which is a normal phenomenon and the current situation. However, because there is no significant recession pressure, the pullback is relatively controllable, as seen in the 2019 rate cut cycleAfter the interest rate cut, benefiting from the demand increase brought by the decline in financing costs, assets that improve the profitability of the numerator end, the relative allocation value rises, and moderate pullbacks also bring better re-entry opportunities. Therefore, after the interest rate cut, one can gradually shift towards assets that benefit from re-inflation, such as leading technology stocks, post-cyclical sectors in the US stock market, and bulk commodities like copper and oil.

Chart: Traditional energy and real estate outperform when the Republican Party wins

► For the US stock market, we are not overall pessimistic. Previously, with valuations on the high side, we recommended "not buying on dips," but after a pullback, it may be worth considering entry. In the past, a decline in the US stock market attracted market attention, but the economic slowdown before the interest rate cut leading to market adjustments was a normal phenomenon. In terms of sectors, small-cap growth stocks that benefited from liquidity in the previous period relatively held an advantage, but they are currently "fighting and retreating"; post-cyclical sectors may see early recovery after the Fed's interest rate cut, while benefiting from leading technology companies in the numerator and denominator and post-cyclical sectors holding an advantage, which is also the case with the upcoming election and interest rate trades. Our calculations show that the short-term technical support levels for the Nasdaq and S&P are around 17,000 and 5,300. If an unexpected downside breakthrough occurs, pressure points are around 16,200 and 4,900, otherwise, there will be consolidation at these levels; but with the expected Fed interest rate cut and financial liquidity recovery, the S&P 500 still has the potential to recover to around 5,500.

Chart: According to our financial liquidity model and US stock valuation profit model calculations, the pressure points for the S&P 500 index to pull back are around 4,900 to 5,100 points

Chart: Sensitivity test for the S&P 500 and Nasdaq indices

Tightening pace: There is still room for further tightening, affecting financial liquidity, corresponding to the market's "first suppression and then rise"

Regarding the issue of tightening, the Fed has not made too many statements. Currently, the Fed is still tightening at a pace of $250 billion in treasuries and $350 billion in MBS per month. When the Fed will end the tightening may still depend on the adequacy of financial liquidity. Currently, the reserve ratio of the US banking system is still very ample, with reserves accounting for 14.2% of total bank assets, continuously decreasing but not yet falling from excessively ample levels to moderately ample levels (13%). Our calculations show that as the tightening has slowed down, reserves can still remain ample by the end of the year ("How will the Fed end the tightening?"). In addition, if the interest rate cut is to return to neutrality rather than stimulate the economy, tightening can continue alongside the rate cut.

Chart: Currently, the reserve ratio of the US banking system is still very ample, with reserves accounting for 14.2% of total bank assets

The Federal Reserve's balance sheet reduction from a quantitative perspective will affect financial liquidity, thereby impacting the market. According to the newly released short-term debt issuance scale by the Ministry of Finance for the fourth quarter (third quarter of the fiscal year), the issuance volume of short-term debt is only $90 billion, resulting in the inability to fully absorb the quarterly balance sheet reduction scale of $180 billion, meaning that there will still be some pressure on financial liquidity for the whole year.

In addition, it is worth noting that in January 2025, the United States will once again face the debt ceiling issue. Before the debt limit is fully resolved, liquidity may be released through the TGA account to hedge the downward trend of financial liquidity indicators. However, after the debt limit is resolved, further debt issuance may lead to a tightening of liquidity. From the current situation of the U.S. election, under the assumption of Trump's victory and a Republican sweep, the debt ceiling issue in 2025 may be resolved more smoothly than in 2023, and fiscal expansion is also more likely. However, due to the uncertainty of the final election results, the composition of the president and Congress still needs to be observed.

Chart: The broad and structural deficit impulses in the United States in 2024 may decline from 1.1% and 1.6% at the end of 2023 to -1% and -2.14%.

Chart: In January 2025, the debt ceiling may once again limit the government's room for credit expansion.

[1] https://www.federalreserve.gov/newsevents/pressreleases/monetary20240731a.htm

[2] https://wallstreetcn.com/articles/3719280

Article authors: Liu Gang S0080512030003, Li Yujie S0080523030005, Yang Xuanting S0080524070028, Wang Zilin S0080123090053, Source: Kevin Strategy Research, Original Title: "CICC: Rate Cut in September is Approaching"