CICC: Fed's restraint is conducive to rate cuts

In the past period, the data fluctuations in the United States have been significant, leading to uncertainty in the market's interest rate cut expectations, causing fluctuations. Just looking at the two data points before this meeting, non-farm payrolls and CPI, the divergence is particularly prominent. The significant outperformance of non-farm payrolls in May surprised the market, while the May CPI, especially the core CPI, cooled faster than market expectations. Against this backdrop, how the June FOMC Federal Reserve will state its position, especially how the "dot plot" will be adjusted, has become the focus of market attention. From the meeting statement and Powell's post-meeting remarks, the Federal Reserve was relatively restrained in this meeting, at least compared to the excitement in the market before the meeting regarding CPI. The biggest change this time is that the "dot plot" was revised from the expectation of three rate cuts within the year in March to one cut (increased from 3 cuts to 4 cuts in 2025), reducing the total number of cuts from 6 to 5. Although CME rate futures show that the market still expects two rate cuts within the year (in September and December), there was not much change in U.S. bond yields and stock market trends after the interest rate decision. However, in our view, the Federal Reserve's approach of "exchanging time for space," preventing the market from prematurely speculating on rate cuts, may actually be the best choice, as it leaves room for future policy actions and learns from the lesson of the market speculating too early, that the less expected a rate cut, the more likely it is to happen. Rate Cut Path: Dot plot revised to one rate cut within the year, a total of 5 cuts; the third quarter remains a window of opportunity There were minimal changes in the meeting statement this time, with just a slight adjustment in wording to reflect the cooling of May CPI. The market focus was mainly on the updated economic data and interest rate forecasts, namely the "dot plot." Compared to the expectations in the March meeting, the "dot plot" revised the number of rate cuts within the year to one, slightly more hawkish than market expectations. Correspondingly, the number of rate cuts in 2025 was increased from the previous 3 times to 4 times, reducing the total number of cuts from 6 to 5. Additionally, the meeting also raised the long-term neutral interest rate (r*), from 2.6% to 2.8%, to some extent reflecting the Fed's belief that interest rates may remain higher for longer than imagined. Furthermore, the Federal Reserve raised its forecast for PCE in this meeting, which can be seen as a recognition and adjustment of the economic changes in the past quarter. Chart: "Dot plot" revised from the expectation of three rate cuts within the year in March to one cut (increased from 3 cuts to 4 cuts in 2025) Source: Federal Reserve, CICC Research Department Chart: In this meeting, the Federal Reserve raised its forecast for PCE, which can be seen as a recognition and revision of the economic changes in the past quarter. Source: Federal Reserve, CICC Research Department Powell's speech did not provide much incremental information, emphasizing that rate cuts are still data-dependent. Even though the Bank of Canada and the European Central Bank started a rate-cutting cycle last week, sparking market expectations of a global "rate-cut wave," Powell's stance remains restrained, stating that the timing of policy adjustments "depends very much on the data" and more inflation data needs to decline to boost confidence, and policy adjustments depend on overall data, not just inflation data. Chart: The Bank of Canada and the European Central Bank have already started a rate-cutting cycle, with the global central bank easing index falling to 13%. Source: BIS, CICC Research Department Overall, the information conveyed in this meeting is more restrained, even more dovish than market expectations, but this restraint and the strategy of "exchanging time for space" may actually be the best approach at the moment, as Powell stated that no Fed official believes that further rate hikes are needed, but the degree of policy tightening is not so strong, leading to a situation where if the market speculates too early on rate cut expectations, it will spontaneously loosen financial conditions through trading, thereby delaying rate cuts. In fact, it was the market's excessive speculation on rate cuts earlier this year (at one point expecting 6-7 rate cuts) that slowed the slope of growth and continuously pushed back the timing of rate cuts. Chart: CME interest rate futures imply two rate cuts starting in September and two rate cuts for the year. ![](https://mmbiz-qpic.wallstcn.com/sz_mmbiz_png/fzHRVN3sYsibPBHpibzJ3tc2Yxqn1MPxT6uS3mncbJ8CiaxwRE7Kn1llQ7ZXxQwUf4qXLrLqzowCcWVSL5cLAYY2A/640? Source: CME, CICC Research Department Several key points conveyed in this meeting are in line with our expectations: 1) Rate cuts are still possible, only in this way can the market be prevented from getting overly excited in advance, maintaining the current tight financial conditions to leave room for future policy operations; 2) The third quarter is a critical window. With core CPI slowing down again to 0.2% after April, we predict that CPI will continue to fall to below 3% in the third quarter, corresponding to PCE falling to around 2.5%, providing room for policy operations. End-of-year inflation tailwinds and the factor of the election will increase the difficulty of the Fed's operations. 3) Overall rate cut of 100-125 basis points. The rate cut magnitude given in the dot plot this time is 125 basis points, consistent with our calculation in the "Global Market Outlook for the Second Half of 2024: More than Halfway Through Easing", a rate cut of around 100 basis points is sufficient to address economic and financial risks. We estimate that a long-term bond rate of around 4% is an appropriate level; considering spread pressure and financial risks, the Fed may only need to cut rates by around 100-125 basis points, from 5.3% to around 4.3%. Chart: CPI and core CPI fell to 2.87% and 3.45% in August Source: Haver, CICC Research Department Chart: Upside risks may be higher than downside risks Source: CICC Research Department Chart: Assuming r* is between 1-1.5%, inflation expectation is 2.5%, term premium is around 0-50bp, and the central point of US Treasury yield is around 4% Source: Bloomberg, CICC Research Department Chart: Considering interest rate differential pressure and financial risks, the Fed may only need to cut rates by about 100bp, from 5.3% to 4.3% Source: Bloomberg, CICC Research Department Chart: The Fed may still cut rates within the year, with the third quarter being a suitable window Source: Bloomberg, CICC Research Department Pace of Balance Sheet Reduction: Starting to Slow Down as Scheduled, Helping to Alleviate Financial Liquidity Pressure As indicated by the Fed in the May meeting, starting in June, the pace of balance sheet reduction will slow down, with US Treasuries decreasing from $60 billion per month to $25 billion per month, while MBS will continue to maintain a reduction scale of $35 billion per month, officially implemented on June 1st. In our article "How will the Fed end balance sheet reduction?", we pointed out that the main consideration for the Fed to stop reducing the balance sheet is the adequacy of liquidity in the money market Reducing the balance sheet is to deal with the risk of potential nonlinear decline in liquidity. The Fed's balance sheet reduction helps alleviate the pressure of financial liquidity contraction. According to our calculations, based on the current scale of balance sheet reduction, assuming that overnight reverse repurchase agreements absorb 0.8% of the short-term debt issuance volume (USD 290 billion) in the third quarter, the current scale of balance sheet reduction (USD 180 billion) can be fully offset by reverse repurchase agreements; as the Treasury has not provided a forecast for the short-term debt issuance scale in the fourth quarter, we assume that 50% of the remaining reverse repurchase scale from the third quarter to the historical low level in 2019 will be released in the fourth quarter (less than the third quarter release), and the scale of balance sheet reduction can also be largely offset. Based on the correlation between financial liquidity and the U.S. stock index, it is estimated that the U.S. stock market may drop by 4-5% from the current level at the beginning of the fourth quarter, with a remaining upside potential of 5-7% for the year to around 5500. Chart: The proportion of reserves to bank assets is close to 15% at present Source: Bloomberg, CICC Research Department Chart: The U.S. stock market may drop by 4-5% from the current level at the beginning of the fourth quarter, with a remaining upside potential of 5-7% to around 5500 for the year Source: Bloomberg, CICC Research Department Asset Implications: Over half of the loose trading, still room for layout, but pay attention to the pace; U.S. bonds at 4% center, golden opportunity stage; U.S. stocks want to rise first, dollar biased towards strength Compared to the Fed's restraint, the market still expects two interest rate cuts this year, in September and December, and the trends of U.S. bonds and stocks have not changed much. From another perspective, this precisely indicates the necessity for the Fed to maintain restraint, otherwise the market may start to speculate on interest rate cuts more quickly. Due to the market's anticipation and reflexivity, coupled with the fact that this interest rate cut was not expected to be substantial, we need to think ahead and moderately counter-think when considering allocation direction and formulating trading strategies. The current shallow interest rate cuts are very similar to the interest rate cut cycles in 1995 and 2019, in other words, the realization of interest rate cuts may also mark the end of interest rate trading, which is also our outlook for the second half of the year ("[Global Market Outlook for the Second Half of 2024: More than Halfway through Easing](https://mp.weixin.qq.com/s? The main implication of the easing may have passed the halfway mark. In fact, the rate cut initiated by the ECB last week also provided me with another possibility and "script" for rate cuts, namely hawkish rate cuts, non-continuous rate cuts, and rate cuts with no market reaction ("ECB Rate Cut: Different Insights"). Specifically, the current easing trade has not ended yet, and rate-sensitive assets such as US Treasuries and gold can continue to be positioned. However, before the rate cut is confirmed, attention should be paid to trading ranges and pace, which are more likely to show a range-bound pattern. When the rate cut is realized, it may also be the end of trading, requiring timely exit, and then shifting to assets that benefit from reflation. ► US Treasuries: There are opportunities in the phase before the rate cut, but attention should be paid to the pace and timely exit, with a central level around 4%. Considering the levels needed for economic recovery and the long-term central level of US Treasury rates, we estimate that a rate of around 4% may be a reasonable level. In terms of pace, the reflexivity of financial conditions will create resistance and support levels, such as short-term fluctuations in US Treasury rates in the range of 4.2% to 4.7%, corresponding to three rate cuts within the year and no rate cuts within the year. After the rate cut, rates may briefly fall below 4%, and the US economy may rebound, potentially missing trading opportunities at that time. Chart: US Treasury trading opportunities are more reflected in the pre-rate cut expectation stage Source: Bloomberg, CICC Research Department ► Gold: There are still phased opportunities before interest rate cuts, with a central tendency of $2500 per ounce. Assuming real interest rates of 1-1.5%, USD 102-106, the reasonable central tendency for gold is $2500 per ounce. There is still room for movement from the current level. After the resumption of interest rate cut trades, gold still has a wave of interest rate cut trading space until one or two interest rate cuts begin. Looking back at historical data since 1995, gold has shown higher gains during interest rate cut expectation phases, indicating that it is the main player in interest rate cut expectation trading. Chart: Assuming real interest rates of 1-1.5%, USD 102-106, the reasonable central tendency for gold is $2500 per ounce Source: Bloomberg, Haver, CICC Research Department ► US Stocks: Short-term cautious optimism, but not pessimistic in the long term. Against the backdrop of difficult substantial repair of economic fundamentals, growth still suppresses profits in cyclical sectors. However, profits in the technology sector are supported by demand from the AI industry, providing support to the overall index. Once interest rates decline and interest rate cut expectations become clear, there may be a 5%-7% upside for the year, with the index around 5500. In terms of rhythm, financial liquidity shows a slight fluctuation in the fourth quarter but still has overall upside potential. Structurally, technology leading stocks with strong short-term profitability and ample cash flow still have a relative advantage, while the cyclical sector awaits the start of interest rate cuts. Chart: Growth still suppresses profits in cyclical sectors, but technology stocks support the overall index Source: Bloomberg, CICC Research Department ► US Dollar: No basis for significant weakening, oscillating in the 102-106 range. Although the Federal Reserve may initiate interest rate cuts, the trend of the US dollar does not solely depend on the Fed's policy actions. Weaker economic fundamentals in the Eurozone and an earlier interest rate cut cycle actually support the US dollar. Moreover, after this round of Fed interest rate cuts, the US economic fundamentals may improve. However, it is worth noting the potential impact of the election on exchange rates Chart: Based on the global USD liquidity index, it is highly probable that the USD will continue to fluctuate in the range of 102 to 106 by the end of this year. Source: Bloomberg, Haver, CICC Research Department Author: Liu Gang, Source: Kevin Strategy Research, Original Title: "Fed Restraint is Beneficial for Rate Cuts" Liu Gang, CFA SAC Certification Number: S0080512030003 SFC CE Ref: AVH867