Significantly cutting interest rates while tightening expectations for rate cuts, what does the Federal Reserve mean?

Early this morning, the United States announced the decision of the September interest rate meeting, lowering the federal funds rate by 50bp to 4.75-5.00%. A new round of interest rate cuts officially begins.

This was a major interest rate meeting, including economic outlook and dot plot.

In terms of economic outlook, the Fed lowered this year's GDP growth forecast from 2.1% to 2.0%, significantly raised the forecast for the unemployment rate from 4.0% to 4.4%. In addition, Powell stated:

1. The benchmark revision indicates that the number of employed persons may be revised downward, therefore, it is believed that a 50bp rate cut is the right choice;

2. If employment data had been released at that time (July interest rate meeting), a rate cut might have occurred in July;

He mentioned these mainly to achieve two purposes: 1. Explain why the initial rate cut was 50bp; 2. Avoid letting the market think that 50bp is a normal step.

Furthermore, in order to further tighten the rate cut expectations, the Fed also provided an extremely hawkish dot plot:

This dot plot suggests that: 1. There will be two more 25bp rate cuts this year; 2. There will be 4 rate cuts of 25bp each next year; 3. There will be two more 25bp rate cuts the year after next.

It is not difficult to see that this rate cut pace is extremely slow. Following this path of expectations, the two-year U.S. Treasury rate should be at 3.78%.

Overall, the Fed played a hedging game, on one hand, the magnitude of the initial rate cut exceeded expectations, on the other hand, the rate cut expectations were tightened through the dot plot.

Market Expectations for Future Rate Cut Paths

Early yesterday morning, the two-year U.S. Treasury rate fluctuated, and the market was somewhat at a loss for the Fed's hedging strategy. In the end, the two-year U.S. Treasury rate settled around 3.60% The interest rate is far from 3.78%, it is obvious that the market does not quite agree with the rate cut path implied by the dot plot, and the market has made some adjustments to this dot plot.

As shown in the above figure, the market accepts a compromise scenario:

1. In the future 4 rate-setting meetings, there will be "small steps and quick runs", with a 25bp rate cut each time, rapidly lowering the upper limit of the federal funds rate to 4%;

2. In the following 4 rate-setting meetings, the pace of rate cuts will slow down, with a 25bp rate cut every other meeting, further lowering the upper limit of the federal funds rate to 3%.

This approach not only takes into account the dot plot from September, but also has a certain degree of realism. To be honest, the rate cut pace implied by the September dot plot is just too slow.

Of course, this path is probably not the actual path. The actual path in the future will be adjusted based on economic data. However, this path is currently the best compromise between the market and the Federal Reserve.

Why is the Federal Reserve tightening rate cut expectations

So, why is the Federal Reserve tightening rate cut expectations? In fact, we just answered this question in the previous article "The Different Effects of Rate Cut Expectations and Rate Cut Reality on the U.S. Stock Market": A substantial rate cut in reality is good for the U.S. stock market, while high rate cut expectations are bad for the U.S. stock market.

As shown in the above figure, high rate cut expectations alone will have two adverse effects: 1. Depreciation of the U.S. dollar and capital outflows; 2. Bond market rally, siphoning off the stock market.

Ultimately, this will lead to a significant adjustment in the U.S. stock market, giving investors the illusion that the economy is about to decline. In fact, this is not closely related to the economic situation. What really matters is not letting rate cut expectations become too optimistic.

However, one of the important goals of the Federal Reserve is to achieve a soft landing for the economy. Therefore, in the rate cut process, it aims to tighten rate cut expectations as much as possible to avoid disruptions caused by overly optimistic rate cut expectations, giving investors the "illusion" of an economic downturn.

Therefore, at the September rate-setting meeting, the combination adopted by the Federal Reserve was: substantial rate cut + tightening rate cut expectations. This combination will result in:

1. A substantial release of liquidity in the monetary fund pool;

2. Decline in the bond market;

3. The US Dollar depreciated slightly;

As shown in the above chart, the yield on the 10-year US Treasury bond rose to 3.72%.

As shown in the above chart, the US Dollar Index experienced significant volatility but did not depreciate significantly.

In the end, we see that the Nasdaq index only experienced a slight decline.

Therefore, in order to ensure a smooth economic landing, the Federal Reserve must control the expectations of interest rate cuts well. They need to lower the federal funds rate while avoiding a rapid decline in rate cut expectations. Otherwise, it will lead to a situation like the one in early August this year.

Impact on the domestic capital market

In the article "The Significance of the Federal Reserve's Interest Rate Cut for A-shares and Cross-border Capital Flows," we discussed a viewpoint: There is only one currency in the world, which is the US Dollar. Currently, the Federal Reserve controls China's money supply curve.

Therefore, a 50 basis point interest rate cut by the Federal Reserve will directly expand China's money supply curve, lower long-term bond yields, boost the Shanghai and Shenzhen 300 Index, and there is no transmission process—Federal Reserve easing does not lead to further easing by the central bank. This is because there is only one currency globally—the US Dollar.

So, what does the People's Bank of China influence? Mainly, it affects the exchange rate, which is like putting a layer of clothing called the Renminbi on the US Dollar. For example, to counter the impact of foreign capital behavior. This process affects the money demand curve.

However, many people have a mistaken belief that lowering reserve requirements and interest rates is monetary easing and is good for total demand in the country. In reality, in the current scenario, only interest rate cuts by the Federal Reserve constitute monetary easing. The impact of domestic reserve requirement and interest rate cuts on total demand depends on accompanying policies. With accompanying policies, the impact of reserve requirement and interest rate cuts on total demand is positive; without accompanying policies, the impact is negative.

As shown in the above figure, due to the existence of funds such as wealth management pools, the feedback of risky assets to the central bank's easing actions is extremely complex. Generally speaking, before important catalyst events, the central bank's easing actions will slowly push down the prices of risky assets; only after the catalyst event, the positive effects of the central bank's easing actions will be fully released, pushing the prices of risky assets sharply higher. This is a very counterintuitive process.

So, when will the central bank regain control of the domestic money supply curve? Only when the domestic policy interest rate is significantly higher than the federal funds rate, it is obvious that we are still far from that state, so let's wait a little longer.

Author of this article: Cang Hai Yi Tu Gou, Source: Cang Hai Yi Tu Gou, Original Title: "On the September Interest Rate Meeting and the Start of the Rate Cut Cycle"