CMB Securities: Balancing risks of US inflation and employment, nearing rate cut but final decision depends on data

According to the Smart Finance app, CMB Securities released a research report stating that the Federal Reserve held a monetary policy meeting on the 31st, maintaining the policy interest rate and the pace of balance sheet reduction unchanged, with a slight relaxation in the inflation target and an increase in the weight of employment. Powell's speech and responses to journalists signaled a balance between inflation and employment risks, approaching a rate cut but ultimately depending on data. The warming rate cut expectations boosted market risk appetite, with major asset classes generally rising; the first rate cut is "data-dependent," while subsequent rate cuts are "watching as we go"; a rate cut may be one of the catalysts for the fading of the stock market's suction effect.

On July 31, 2024, local time, the Federal Reserve held a monetary policy meeting, maintaining the federal funds target rate unchanged in the range of 5.25%-5.50%, consistent with the pace of balance sheet reduction and the decision of the June monetary policy meeting, namely reducing holdings of $25 billion in U.S. Treasuries and $35 billion in MBS per month, in line with market expectations.

The Federal Reserve kept the policy interest rate and the pace of balance sheet reduction unchanged, with a slight relaxation in the inflation target and an increase in the weight of employment. There are three incremental pieces of information in the FOMC statement: first, the assessment of employment has shifted from "strong" to "moderated" for the first time since the January FOMC meeting; second, the description of inflation has changed from "at elevated levels" to "to some extent at elevated levels," also for the first time since the January FOMC meeting; third, the return of dual risks. Since May 2022, the focus of the Federal Reserve's policy has been on combating inflation - "the Committee is highly concerned about inflation risks," but this meeting marked a shift - "the Committee is highly concerned about the risks of its dual mandate."

Signals from Powell's speech and responses to journalists: a balance between inflation and employment risks, nearing a rate cut but ultimately data-dependent.

1. Economy: Still resilient. Economic activity continues to expand at a steady pace; consumer spending has slowed from last year's strong pace but remains solid; equipment and intangible asset investment have recovered from last year's slump, with real estate investment sharply rising in Q1 and stagnating in Q2; the probability of a hard landing is low at present.

2. Employment: Labor market cooling slightly. Job growth in Q2 was slightly slower than in Q1, but still solid; the unemployment rate has risen slightly but remains at a low level; the labor market conditions have returned to pre-pandemic levels - strong but not overheated.

3. Inflation: Making noticeable progress, but confidence needs to be strengthened. Goods, non-housing services, and housing services in core PCE have all seen significant progress, with Q2 inflation data boosting confidence, and more positive data will further strengthen this confidence.

4. Rate path: The timing for a rate cut is gradually maturing, with a possible first rate cut in September but dependent on data support. When responding to journalists, Powell stated that a rate cut in September is "under consideration," but the premise is that overall data, not just individual data, meets the Fed's expectations. The explanation for "no rate cut at this meeting" is that while the committee generally believes the economy is nearing an appropriate time for a rate cut, it is not yet fully mature. Under the current circumstances, the policy rate is expected to start to decline from its current level. In addition, Powell does not want to set a specific path or forward guidance for rate cuts, considering zero to multiple rate cuts based on economic conditions.

Market reaction: Warming rate cut expectations boost risk appetite, with major asset classes rising. Various assets rose before the FOMC decision was announced, and the gains expanded after the decision and Powell's speech 2Y and 10Y US Treasury yields fell by 10.1BP and 10.6BP to 4.27% and 4.04% respectively; the US Dollar Index dropped by 0.43% to 104.04; COMEX gold, WTI crude oil, and LME crude oil rose by 1.70%, 5.23%, and 2.99% respectively; the S&P 500, Nasdaq, and Dow Jones indexes rose by 1.58%, 2.64%, and 0.24% respectively. Market expectations for interest rate cuts have slightly increased, with an 87.5% probability of a 25BP rate cut in September and a 66.4% probability in November.

The first rate cut is "data-dependent," while subsequent rate cuts are "wait-and-see." Despite Powell's efforts to maintain risk neutrality and data dependence, the market still interprets it as neutral to dovish, mainly due to the possibility of a rate cut in September. According to Powell, if the economic and employment data in July-August deteriorate or inflation further declines, it could trigger a rate cut in September. Therefore, going forward, each confirmation of economic data strengthens the expectation of a rate cut, while deviations in data (such as resilient inflation) will lead the market to readjust the rate cut path. In addition, Powell mentioned that "there is currently only one quarter of positive inflation data," so if a rate cut lands in September, the Fed may reserve a quarter window to "wait and see," making consecutive rate cuts relatively stringent and subject to observation.

Why is a rate cut before the election possible? CMB Securities has repeatedly expressed the view in reports such as "Left and Right" at the March interest rate meeting and "Neither Advance nor Retreat" at the May interest rate meeting that it may be difficult to cut rates before the election. The main reason is that Biden's approval rating trend basically reflects voters' attitudes towards inflation. In Q3 2021, US inflation began to rise, and Biden's support rate plummeted; in June 2022, Biden's support rate hit its lowest level before the first debate in June this year, corresponding to the peak of this round of US CPI year-on-year; in Q4 last year, Biden's support rate fell below 40% again, which is related to the premature end of rate hikes despite ongoing high inflation. Furthermore, if Biden still has a chance of winning, a rate cut before the election will inevitably be unfavorable to his prospects, and there may be attempts to obstruct it. However, the situation changed after the first debate, especially after Biden withdrew. Inflation is no longer linked to the candidates' prospects, and the Fed can more independently drive monetary policy decisions.

Rate cuts may be one of the catalysts for the fading of the stock market's suction effect. From the end of 2023 to February this year and in June this year, the resonance of the US dollar and US stocks strengthened, intensifying the suction effect of US stocks and putting pressure on non-US assets in the short term. With the recent possibility of a rate cut by the Fed in September and the Bank of Japan reversing its rate hike, the yen depreciation trend has been reversed. In addition, rate cut expectations have fueled concerns about a slowdown in the US economy, cooling the suction effect of US stocks and increasing the focus on non-US assets. Moreover, a series of internal changes such as the Third Plenum, central bank rate cuts, and proactive fiscal policies have gradually improved domestic equity performance.

It is worth noting that in the report "Autonomous and Controllable Assets" on July 29th, CMB Securities pointed out that the RMB exchange rate is likely to fluctuate in the range of "7.0-7.3" currently; and defined domestic interest rate bonds and state-owned equity assets with high dividends as "autonomous and controllable assets" (not influenced by external and foreign capital). Obviously, if the Fed continues to cut rates, internal factors gradually improve, and domestic risk appetite remains on the rise, such assets will undergo continuous adjustments However, if the sustainability of the Fed rate cuts and internal changes remain uncertain, then "autonomous controllable assets" still have allocation value