A research report by China International Capital Corporation (CICC) pointed out that since July, various assets have shown a "roller coaster" trend, which implies a swing in expectations of the Federal Reserve's interest rate cuts. Due to the dilemma of whether the Federal Reserve can initiate a rate cut in September, concerns about a slight rate cut, and the potential inflationary pressure brought about by Trump's trade, the US Treasury has maintained a fluctuation range of 4.3% -4.5%; After the inflation data significantly cooled down in June, the trend shifted towards interest rate cuts, and gold rose by nearly $2500 per ounce; In July, the weakening of the manufacturing PMI and non farm payroll triggered recession concerns, and it was even expected that the Federal Reserve may urgently initiate a significant interest rate cut. The US Treasury and the US dollar quickly fell to 3.7% and 102, and the US stock market experienced a significant pullback.
Recently, the service sector PMI and retail data have strengthened, and the market has returned to the expectation of a slight interest rate cut by the Federal Reserve under a "soft landing". How to determine the policy path after the expected "turnaround" in the market? How many expectations have been included for various types of assets, is it already excessive or is there still room for improvement? China International Capital Corporation (CICC) conducts quantitative analysis in this article.
The following are its core viewpoints:
What is the policy path of the Federal Reserve? September is highly likely to start, but overall interest rate cuts are limited under the benchmark scenario of a 'soft landing'
The expectation of a significant and urgent interest rate cut based on recession concerns is not realistic. Prior to the September FOMC, inflation, non farm payroll data for August, and this week's Jackson Hole meeting may further confirm the policy path.
How much interest rate reduction expectation has been included in various assets? Ranking of 'rushing' degree, interest rate futures>; Gold>; Copper>; US Treasury>; US shares
Interest rate futures imply the highest number of interest rate cuts in the next year (7 times), followed by gold (2.6 times), copper (2.4 times), and short-term bonds (2.3 times). The US stock market (0.8 times) has the lowest expected interest rate cuts. In other words, if the interest rate cut path is lower than expected, the US stock market will not be under great pressure simply because of this, and the profit outlook will be more important.
What is the future trend of assets? Before the interest rate cut, US Treasury bonds and gold were in a wave, and after the cut, they gradually shifted towards pro cyclical assets
Before the interest rate cut, denominator assets such as US Treasury bonds and gold can continue to be held, but due to expectations of a rush and limited overall room for interest rate cuts, they are more focused on "hitting the wave". After the interest rate cut, as the fundamentals gradually stabilize and repair, it is possible to switch to pro cyclical assets and sectors.
The following is the main text of the research report:
1、 What is the policy path of the Federal Reserve? September is highly likely to start, but overall interest rate cuts are limited under the benchmark scenario of a 'soft landing'
There is a high probability of interest rate cuts starting in September, and the market has fully taken into account this. From the perspective of the Federal Reserve's policy objectives and recent statements from officials, it is highly likely that interest rate cuts will begin in September. On the one hand, inflation will fall towards the 2% target, and the labor market will also cool down. The overall and core CPI continued to decline year-on-year in July, with the unemployment rate rising to 4.3% and non farm payroll job creation lower than expected, paving the way for the Federal Reserve to cut interest rates in September; On the other hand, recent statements by Federal Reserve officials have been dovish, initiating a warm-up for interest rate cuts. Especially Powell emphasized in multiple speeches such as interviews with the Washington Economic Club that there is no need to wait for inflation to drop to 2% before cutting interest rates, fearing that cutting interest rates too late will put pressure on the economy. The recent market turbulence will also increase the pressure on the Federal Reserve to worry about cutting interest rates too late. There is no disagreement in the market regarding September as the first time to cut interest rates. The current CME interest rate expectation implies a 100% probability of a rate cut in September, but the magnitude is different. The probability of a 25bp rate cut is expected to be higher, reaching 75%, which is consistent with Powell's denial of the possibility of a 50bp rate cut in a post FOMC interview in July.
Chart: Powell's recent major statements and speeches are generally dovish
Source: Bloomberg, Research Department of CICC
However, under the benchmark scenario, the overall rate cut for this round may be limited (4-5 times, around 100bp), and the expectation of a significant and urgent rate cut based on recession concerns is not realistic. We have reviewed the synchronized and leading indicators of the fundamentals of the US economy, and examined the factors that triggered the recession. We have determined that the US economy is currently in a downward trend, and the growth rate of corporate income is gradually slowing down. However, due to the existence of different "seesaws" between various links, they can hedge against each other, and the overall economy does not have the pressure to slow down comprehensively. At the same time, the gap between private sector financing costs and investment returns is not significant, and the suppression of demand by monetary tightening is marginal. Therefore, a certain degree of interest rate reduction can reignite demand. For example, at the beginning of the year, the market trading was loose, and the long-term bond interest rate fell to 3.8%, leading to a relaxation of overall financial conditions. The year-on-year growth rate of residential mortgage loans and the scale of corporate bond issuance reached a new high since 2022. In this case, we estimate that cutting interest rates 4-5 times (around 100bp) can alleviate the restrictive nature of monetary policy, and demand and growth may return to an upward channel, corresponding to a 10-year US Treasury central 4%. In addition, the fourth quarter inflation has lifted, and the price pressure has rebounded due to improved demand after interest rate cuts, as well as the inflationary nature of multiple policies from both parties, may also constrain the magnitude of this round of interest rate cuts.
Chart: The 30-year mortgage interest rate of the US residential sector has fallen below the rental return rate
Source: Haver, Research Department of CICC
Chart: The financing cost of the US corporate sector (6.6%) is slightly higher than the investment return rate (5.9%)
Source: Haver, Research Department of CICC
Chart: We expect various sectors of the US economy to show a "downward trend and upward trend" in the second half of the year, followed by a "soft landing" after interest rate cuts
Source: Research Department of China International Capital Corporation
Before the September FOMC, key data and this week's Jackson Hole meeting may further confirm the policy path. Prior to the September FOMC meeting (September 16-17), the Jackson Hole Global Central Bank Annual Meeting (Powell's speech on Friday, August 23), August Non farm payroll (September 6), and CPI (September 11) will also have an impact on the policy path. Our preliminary estimate is that both the overall and core CPI will continue to decline, with the overall CPI falling from 2.9% in July to 2.6% in August year-on-year, and the core CPI falling from 3.2% in July to 3.1% in August year-on-year, which is in line with Powell's test of "inflation continuing to fall and the job market maintaining stability", and has limited impact on the path of interest rate cuts starting in September.
Chart: Overall and core CPI continued to decline year-on-year in the third quarter; Fourth quarter or slightly upturned tail
Source: Haver, Bloomberg, Research Department of CICC
Powell may reiterate the downward trend of inflation and the balance of employment targets in his speech at this week's Jackson Hole meeting, sending a signal of moderate interest rate cuts. The Jackson Hole Global Central Bank Annual Meeting brings together central bank governors, finance ministers, heads of international institutions, and economists from around the world to discuss the most critical economic and monetary policies in the world, with the speech of the Federal Reserve Chairman receiving the most attention. The theme of this year's conference is "Re evaluating the Effectiveness and Transmission of Monetary Policy". As a prelude to the Federal Reserve's current interest rate cut cycle, we expect Powell to continue his previous moderate "dovish" stance, emphasizing that "the Fed's interest rate cuts do not necessarily require inflation to fall back to 2%, only a trend towards a 2% decline in inflation", while conveying to the market the Fed's balance between inflation and employment targets.
Chart: The Federal Reserve's dot matrix chart predicts one interest rate cut this year and four interest rate cuts next year
Source: Federal Reserve, Research Department of CICC
2、 How much interest rate reduction expectation has been included in various assets? Ranking of 'rushing' degree, interest rate futures>; Gold>; Copper>; US Treasury>; US shares
Despite the Federal Reserve's July FOMC statement warming up for a rate cut in September, the market clearly expects the Fed to "do earlier and do more" after experiencing weak employment and data in July. With the warming "recession narrative," US bonds and the US dollar have significantly weakened, and US stocks have also seen a clear pullback. However, in the past two weeks, some data including service sector PMI and retail have shown that the economy still has resilience, with major assets rebounding from extreme recession concerns, US bond rates rising from a low of 3.7% to 3.9%, and US stocks recovering 80% of their previous losses. Compared to the possible paths discussed earlier, how many expectations have been included for various types of assets at present? Has it been excessive or is there still room? Specifically, let's take a look:
Chart: We calculate the expected rate cuts for interest rate futures, gold, and US stocks in the next year, including 175bp, 65bp, and 21bp, respectively
Note: Data as of August 16, 2024 Source: Bloomberg, Federal Reserve, Research Department of CICC
Interest rate futures: Implies 7 interest rate cuts in the next year. The current interest rate futures imply a 3.8% interest rate level for August 2025, and there will be 7 more interest rate cuts in the next year compared to the current federal funds rate level. The specific path implied by CME interest rate futures is to raise interest rates by 25bp for the first time in September, then by 25bp each in November and December, by 50bp in January 2025, and by 25bp each in March and June.
Chart: CME Interest Rate Futures Implies First September Rate Cut of 25bp
Source: CME, Research Department of CICC
Gold: Implies 2.6 interest rate cuts in the next year, second only to CME interest rate futures. Based on the relationship between real interest rates, the US dollar, and gold, we estimate that the implied real interest rate of the current gold price (~2508 US dollars/ounce) is 1.76%, slightly lower than the current real interest rate of 1.80%, second only to more interest rate futures. Gold is included in the expectation of more interest rate cuts, corresponding to a 64.7bp interest rate cut in the next year.
Chart: Based on the relationship between real interest rates and gold, we estimate that the current gold price (~2508 USD/oz) implies a real interest rate of~1.76%
Source: Bloomberg, Research Department of CICC
Copper: Implies 2.4 interest rate cuts in the next year, lower than CME interest rate futures and gold. Based on inflation expectations and the relationship between the US dollar and copper prices, we estimate that the current copper price (~415 US dollars/ton) implies an inflation expectation of 2.10%, slightly higher than the current real level of 2.08%, corresponding to a 58.8bp interest rate cut in the next year.
US Treasuries: Short end US Treasuries imply 2.3 interest rate cuts in the next year, while long end US Treasuries have fallen below our estimated 4% threshold, indicating that expectations for shorter end bonds are more sufficient. The current one-year US Treasury bond is included in the next one-year interest rate cut of 56.7 basis points, which is 10 basis points lower than the increase in recession concerns, indicating a decrease in the necessity for the Federal Reserve to urgently cut interest rates significantly. Under the influence of weak non farm payroll data and the "recession narrative" sentiment of global equity market fluctuations at the beginning of last week, the long-term US Treasury bonds quickly fell below the 3.7% mark. However, the resilient economic data in the past two weeks has pushed the long-term Treasury bonds back up to around 3.9%, but still slightly lower than the central level of 4% we estimated, indicating that the expectation of interest rate cuts included in long-term bonds is also relatively sufficient.
Chart: Based on the relationship between valuation, credit spread, and interest rates, we estimate that the current dynamic valuation of the US stock market implies a 10-year US bond interest rate of 4.45%
Source: Bloomberg, Research Department of CICC
US stock market: Implies 0.8 interest rate cuts in the next year, making it the asset with the least expected interest rate cuts among all types of assets. Based on the relationship between US bond interest rates, credit spreads, and dynamic valuations of US stocks, we estimate that the implied 10-year US bond interest rate at 21.2 times the current dynamic valuation of the S&P 500 index is 4.45%, corresponding to a 20.6bp rate cut in the next year, which is the least expected rate cut among all asset classes. In other words, if the interest rate cut path is lower than expected, the US stock market will not be under great pressure simply because of this, and the profit outlook will be more important.
3、 What is the future trend of assets? Before the interest rate cut, US Treasury bonds and gold were in a wave, and after the cut, they gradually shifted towards pro cyclical assets
Based on the downward trend of inflation and official statements from the Federal Reserve, we believe that the policy path is relatively certain, which is to start cutting interest rates in September, but the overall magnitude is limited. Due to the fact that various assets have already been included in the expectation of interest rate cuts, denominator assets such as US bonds and gold can continue to be held before the interest rate cuts. However, due to the anticipated rush and limited overall space for interest rate cuts, it is more of a "wave band" rather than a recommendation to increase more positions. It is advisable to "fight and retreat". After the interest rate cut, as the fundamentals gradually stabilize and repair, we can gradually switch to pro cyclical assets and sectors. Specifically, let's take a look:
Before the interest rate cut is realized, loose trading in US bonds and gold may benefit relatively, but the space is limited, making it more suitable to "hit the wave" before the interest rate cut. 1) We estimate that the central level of long-term bonds in this round of interest rate cuts is about 4%, and the realization of interest rate cuts may drop to a low of 3.8%. Therefore, the downward range from the current 3.9% level is limited; 2) Compared to US Treasury bonds, we have calculated a reasonable central strength for gold at $2500 per ounce based on the fundamental model of real interest rates (1-1.5%) and the US dollar (102-106) (without considering other geopolitical and hedging factors).
Chart: Approximately 4% of the US Treasury bond market; Redemption of interest rate cut with a downward impact (3.7%), timely withdrawal after redemption of interest rate cut
Source: Bloomberg, Research Department of CICC
Chart: Based on the annual real interest rate of 1-1.5% and the range of 102-106 US dollars, the central price of gold may be around 2500 US dollars per ounce
Source: Bloomberg, Research Department of CICC
After the interest rate cut is implemented, assets that only benefit from the denominator end gradually shift to those that benefit from profit recovery at the numerator end, such as US stocks and copper. Before the interest rate cut, under the amplification of emotions, weak economic data or risk events will bring significant downward pressure to risk assets such as the US stock market and copper. But for risk assets, we are not pessimistic. Combining our judgment on the path of this round of interest rate cuts and fundamental repair, the pullback actually provides better opportunities for intervention, and we can wait for demand repair after the interest rate cuts and policy stimulus expectations after the election.
Chart: This round of interest rate cuts is similar to the soft landing of a small rate cut in 2019. Before the rate cut, US Treasury gold dominated, but later switched to US stocks and copper
Source: Bloomberg, Research Department of CICC
Before the September FOMC meeting, we sorted out the economic data and events that the market may be concerned about, including: the Democratic National Convention (August 19-21), the August Markit PMI data (August 22), Powell's speech at the Jackson Hole meeting (August 23), the August ISM manufacturing PMI (September 3), the August ISM services PMI (September 5), the August unemployment rate and non farm payrolls (September 6), and the August CPI (September 11).