On the eve of the FOMC | Dong Chao from Xingzheng Macro: The real easing will occur in the second half of next year, and opportunities for the RMB are rising

Q1: This FOMC is the last interest rate meeting of the year. What is your judgment on the actions and signals from this meeting? How does the market expect interest rate cuts? Will there be any early release of policy direction for 2026? Duan Chao: This FOMC is one of the most important macro events this week. Let me state my conclusion first: I believe there will still be a rate cut this time, but the forward guidance on the future path may not be very "dovish," but rather more data-dependent. The market's expectation for this rate cut has actually gone through a "roller coaster": Initially, the probability of a rate cut in December was close to 100%; Then, influenced by inflation data and officials' statements, it dropped to about 40%; the latest view shows that the market implied probability has returned to about 90%. Considering the recent statements from Federal Reserve officials, I believe another rate cut this time is a high-probability event. The more important point to watch after the rate cut is: will there be a more accommodative forward guidance for 2026, or will it emphasize "data-dependent, flexible decision-making"? There is a divergence on this point. Currently, the mainstream expectation for rate cuts next year is about 3 times, totaling around 75 basis points. My view is—the U.S. cannot do without accommodation, and the actual number and magnitude of rate cuts next year may exceed current expectations, but the pace may lean towards the latter half of next year, with caution maintained in the early stages. Q2: Your overseas annual report is titled "Unavoidable Accommodation." Can you elaborate on why you believe the U.S. may experience unexpected accommodation in 2026? Is it due to the Federal Reserve's leadership change, falling inflation, or Trump's policy demands? Duan Chao: Simply put, the two clues of fiscal policy and AI ultimately point to monetary accommodation. First, the U.S. government itself has a very strong demand for accommodation. The core challenge faced by the Trump administration in its second term is fiscal unsustainability and government credit issues. To balance the budget, interest expenses need to be lowered; to lower interest expenses, rate cuts + extending long-term rates are necessary. Second, the current growth model of the U.S. economy heavily relies on AI-related investments and the prosperity of the tech sector. We see that leading tech companies are accelerating bond financing, and interest rates are not low. This model is very sensitive to liquidity and interest rate environments; to avoid a repeat of the internet bubble, a more accommodative monetary environment is needed to support this narrative. Combining these two lines, the conclusion is clear: the economic clues, fiscal demands, and tech narratives in the U.S. are all pushing the Federal Reserve towards a more accommodative stance. Another very critical point in time is the change of the Federal Reserve Chair on May 23 next year. The Federal Reserve has 7 governors, and if the White House can control 5 of them, it can almost substantively control the board. Under the current arrangement, after the chair change next year, the Trump administration is expected to control 4 out of 7 seats; if the ongoing adjustment of Governor Cook also materializes, it could become 5 seats Once this situation arises, the White House's influence on monetary policy will significantly increase, opening up space for interest rate cuts and the use of unconventional easing tools. This is what I emphasized in the report: Based on both fundamentals and personnel structure, the United States is likely to "rely on easing" in 2026. Q3: In your report, you described the current U.S. economy as "top-heavy." What specifically does this refer to? How fragile is this structure? Duan Chao: I used "top-heavy" because investment and consumption are now highly concentrated in a few sectors and among a few groups. First, from the investment perspective, it is highly concentrated investment represented by AI. In the first two quarters of 2025, the contribution of AI-related hardware and software investment alone to the U.S. GDP was over 1 percentage point on a quarter-on-quarter basis. In an economy where overall growth is not particularly high, this is a significant boost. The share of AI-related investment in GDP has noticeably increased this year, becoming a key engine of the U.S. economy. Second, from the consumption perspective, it is the "head-heavy" consumption of high-income groups. The U.S. has always been a consumption-driven economy, but a significant change over the past two to three decades is: In the mid-1990s, the top 10% of income earners contributed about 30% of U.S. consumer spending; Today, this top 10% has contributed nearly half of consumer spending. Behind this, of course, are the wealth effects brought by the stock market rise and the AI narrative, but the downside is: The resilience of the economy increasingly relies on AI investment + the wealthiest 10%. This is what I mean by "top-heavy": The top is very strong and eye-catching; But once AI investment slows down, or the asset prices of high-income groups correct, the drag on the overall economy will also be magnified. Q4: Recently, there has been much discussion: Is this wave of AI in the U.S. a bubble? What is your view on the current risks in the AI sector? Is it a reasonable premium or exuberance in a bubble? Duan Chao: I think we need to first agree on a definition of "bubble." If we are talking about a systematic, steep, and rapid decline similar to the bursting of the internet bubble, I believe we may not reach that stage next year; but if we are talking about valuations and narratives being somewhat ahead of themselves, with amplified volatility, I think there are already quite obvious signs of a bubble. From several perspectives: First, compared to the internet bubble of the past, many leading AI companies now have much better profits and cash flows, and overall valuations on many metrics are not even at the extreme levels of that time. Second, if we look at the pull on the real economy and the willingness to pay at the end, the current AI narrative and the internet story of the past actually do not differ as much as imagined, which means that the part where "the story is ahead of the fundamentals" has already been accumulating Third, when the internet bubble burst back then, an important trigger was the tightening of the macro environment—interest rate hikes and liquidity tightening, combined with the depletion of corporate cash flow. However, the current environment is quite the opposite: As we mentioned earlier, the United States still relies on easing; Although the cash flow of leading AI companies is under pressure, they are still far from "running out of cash." So my judgment is: Next year, the volatility of AI-related assets will significantly amplify, with considerable adjustments and fluctuations; But to reach a level of "systemic collapse" similar to the internet bubble, it may take longer and more extreme macro-triggering conditions. In summary: Risks are accumulating, volatility will increase, but next year will be more like "a year of high volatility," rather than "a year of ultimate bubble collapse." Q5: In the context of high debt and high deficits, what kind of interaction will form between federal fiscal and monetary policy? How will this interaction feedback to the US dollar and US Treasury bonds? Duan Chao: Since this year, the issue of unsustainable US fiscal policy has officially "taken center stage": On one hand, the fiscal deficit is high, interest expenditures are rising rapidly, squeezing other expenditures; On the other hand, the market is beginning to reassess the "safety" of US dollar assets as long-term allocation assets. This year we have already seen two signs: First, US Treasury yields have fluctuated sharply at high levels; Second, the US dollar index has depreciated by more than double digits throughout the year. Trump attempted to alleviate pressure through two paths: First, using tariffs to "increase revenue." From January to October this year, the US federal government collected about $140 billion more in tariffs than last year; combined with increased personal income tax and decreased student loan expenditures, this year’s deficit has narrowed somewhat, which has created some space for tax reduction legislation. However, compared to the estimates from the Congressional Budget Office (CBO), the "Beautiful Big Bill" may lead to a deficit expansion of $486.8 billion in the fiscal year 2026, while the current tariff revenue for the entire year is only about $250 billion to $300 billion, far from filling this gap. Second, using trade and tariffs as leverage to encourage Europe, Japan, and South Korea to increase investments in the US. Ideally, such investments could boost US non-residential investment, contributing an additional approximately 0.5 percentage points to GDP. However, from a practical execution perspective, there is uncertainty regarding how much can be realized and the pace of implementation. Overall, my judgment is: In the short term, with the implementation of tax cuts and a temporary recovery in the economy, the dollar may have some phase support; But from a medium to long-term perspective, the weakening of the dollar may not be over, and this year's depreciation does not necessarily mark the end; US Treasury bond yields are likely to trend downward, but the pace will be slower than that of the dollar. More importantly, the US is transferring some of the sovereign credit and long-term interest rate pressures to Europe and Japan through tariffs and trade arrangements. Therefore, in the coming years, the debt repayment risks may be more evident in Europe and Japan, while the relative advantages of US Treasury bonds may be amplified Q6: Under the combination of interest rate cuts and falling inflation, will U.S. stocks and U.S. bonds rise together in the next year, or will there be significant differentiation? What is the pressure situation for other economies outside of China and the U.S.? Duan Chao: I am relatively optimistic about the U.S. itself; the real pressure may fall more on other economies outside of China and the U.S.. For U.S. stocks, the logic is quite direct: Next year is likely to be an environment of relatively loose liquidity, but the economy will not experience a "hard landing"; In this combination, it is relatively friendly to risk assets, especially equity assets; From the perspective of the U.S. itself, seeking new growth points and engaging in great power competition, technology remains the core theme. I still believe that: Next year, the volatility of the technology sector will be greater than this year, but it is unlikely to reach the point of "main line exit." For U.S. bonds, under tighter coordination between fiscal and monetary policies, the Federal Reserve is expected to cut interest rates, and the interest rate center of the entire U.S. bond curve is likely to fluctuate downward. The real risks may be greater in: Europe, where there is heavier pressure for fiscal expansion and weaker coordination between monetary and fiscal policies; Japan, where inflation expectations are rising, and interest rate hikes are occurring alongside fiscal expansion; And some emerging markets that are highly dependent on external financing. In short: U.S. stocks and U.S. bonds may not be perfectly worry-free, but the overall environment remains favorable for U.S. assets; the real concern should be those economies outside of China and the U.S. that are relatively weak in terms of fiscal, monetary, and external balance. Q7: Back to China, your domestic annual report title is "New Supply Breaks the Low Inflation Dilemma." What does "new supply" refer to? What is the fundamental difference from traditional demand-side stimulus? Duan Chao: In the past two years, discussions about the Chinese economy have almost all focused on whether "demand is insufficient and whether another round of strong stimulus is needed," but I believe this may not be the core contradiction at the current stage. My understanding is: In recent years, China's problem is more like a structural imbalance between supply and demand, rather than simply "insufficient demand." The actual GDP growth rate is around 5%, but inflation is near zero or even negative, nominal growth is low, and corporate income, fiscal revenue, and household income are all suppressed, so people's "perception" is not good. An important reason for this situation is that for a long time we have overly relied on a traditional model of "demand-side + industrial competition": Local governments engage in industrial competition around GDP growth, investing heavily in many redundant constructions and low-return projects; The result is that manufacturing investment and capacity expansion are ahead, while demand-side recovery lags behind; In the long run, this will suppress prices, profits, and ultimately income and inflation. The core of my proposal for "new supply" is to shift the focus from "another round of major stimulus" to "slowing down + increasing efficiency": First, appropriately reduce the obsession with high growth rates and pay more attention to structure and efficiency; Second, abandon the traditional "industrial championship" and eliminate backward and excess capacity; Third, shift more resources from simple "investment in objects" to "investment in people" and high-quality service supply. In summary: New supply does not mean no growth, but rather restoring prices and expectations by clearing inefficient supply, improving productivity, and enhancing service quality. I also noticed that a recent series of documents, including the "14th Five-Year Plan" proposal and the Central Political Bureau meeting, increasingly express the idea from the perspective of optimizing supply, unifying the large market, and combating involution, which aligns with the "new supply" concept in our report. Q8: Under this "new supply" framework, does China have the opportunity to truly emerge from low inflation around 2026? How do you judge the timing? Duan Chao: In the report, I created a relatively systematic supply-demand gap model, measuring demand in the economy (consumption, exports, infrastructure, real estate) and supply (capacity formed by manufacturing investment), and then analyzing the gap. I found a phenomenon: This "supply-demand gap" has about a 6-8 month lead on PPI (excluding oil prices). In the past fifteen years, the two phases of significant price and profit recovery—such as in 2016-2017 and around 2021—were both periods where demand improved faster than supply; whereas since 2023, the situation has been the opposite: actual growth is not low, but investment, especially manufacturing investment, is expanding faster, suppressing demand, leading to weaker prices, profits, and nominal growth. Since the second half of this year, with: External demand maintaining a certain resilience; Policies to combat involution being promoted, leading to a significant slowdown in manufacturing investment; The supply-demand gap has gradually returned from negative values to close to zero. According to the model's leading relationship, starting in mid-next year, PPI (excluding oil) is expected to gradually return to zero. On this basis, if we continue to adhere to the "new supply" concept after next year: Keep the growth rate of manufacturing investment at a more reasonable and slightly lower level; Maintain stable demand without large-scale stimulus; Then I expect: In the second half of 2026 to early 2027, there will be an opportunity to see PPI sustainably return above zero; At that time, we can truly say we have "emerged from low inflation," rather than experiencing a brief rebound. The most critical point here is to adjust the mindset: Do not place hope on a single "big stimulus," but rather see if supply-side adjustments can "quietly" change the entire price and profit environment. Q9: In your report, you mentioned paying special attention to the opportunity for the RMB to "actively appreciate." What is the basis for this judgment? Is it based on the accumulation of funds in the current account and capital account? Duan Chao: This is the final part of our macro narrative "trilogy" this year. In the first two parts, we discussed: The overall expectation for China's macroeconomics has shifted from "excessively pessimistic" to "repricing"; There has been a correction in the narrative regarding the real estate crisis model and technological shortcomings. In the third step, we focus on the exchange rate, with the core judgment being: The depreciation of the RMB in recent years has significantly deviated from China's own productivity and the fundamentals of the current account, with a strong component of "emotion and expectation." I conducted two sets of calculations: First, the "retained funds" in the current account. Many enterprises and institutions have made money overseas but chose not to convert it back, leaving it abroad. We roughly estimate that this portion has accumulated to nearly USD 1 trillion over the past three years. Second, the "outflow funds" under the capital account. This includes residents exchanging currency and some institutional allocations, totaling about USD 300 billion over three years. In total, this amounts to 8 to 9 trillion RMB in funds that have created "downward pressure" on the RMB in previous years. However, if domestic macro expectations improve and capital market opportunities are re-recognized, even if only 10% to 20% of this capital flows back, it could transform from a "source of pressure" to a "driving force" in the future. Adding two more factors: First, if the Federal Reserve enters a more pronounced easing cycle after the leadership change next year, the dollar itself may face new depreciation pressure; Second, the domestic emphasis on the internationalization of the RMB, pricing in RMB, and its use as a reserve is increasing. Considering these aspects, my judgment is: Around 2026, there is a high probability that the RMB will experience a phase of "active appreciation." From an asset allocation perspective, I view the RMB exchange rate as an asset with good odds and winning probability: it has fundamental support and the forces of expectation and policy are gradually converging. Q10: If the RMB indeed experiences a wave of active appreciation, it will inevitably boost the attractiveness of Chinese assets. What do you think the overall allocation strategy for Chinese equities, bonds, and commodities will be in 2026? How should investors approach personal allocation? Duan Chao: Based on the current macro environment and policy clues, my overall framework for next year is "strong equities, weak bonds, and moderate inflation recovery." Regarding the equity market, I have a few judgments: First, as long as inflation rises moderately from extremely low levels, corporate profits are expected to move from near-zero growth to a clearly improving phase. Second, if the RMB appreciates actively, the outflow funds that suppressed Chinese assets in previous years may turn into an important "inflow force." Third, from the perspective of valuation and the cost-effectiveness of stocks versus bonds, the relative value of equities remains higher than that of bonds, although it has narrowed significantly compared to the end of last year. In terms of industry style, I will focus on two categories: The first category is the technology and AI growth sectors that have already performed well this year; this is a long-term main line, but volatility may be greater next year; The second category is what I refer to in my report as the "steady happiness" sectors—industries that have room for recovery as prices and profits rebound, but currently have low allocation ratios, such as non-bank financials, utilities, construction materials, agriculture, forestry, animal husbandry, and fishery For bonds, I tend to define next year as a "volatile defense, with average cost-effectiveness": Interest rates have been hovering at low levels, and there is limited room for further decline; it is more about rhythm rather than opportunities in a major direction. Regarding commodities: In my view, the logic of gold has not yet played out. As long as there is a combination of "easing + debt + geopolitical risks + discounted dollar credit," gold will be a variety worth long-term allocation; Industrial metals will depend more on global demand, especially the resonance recovery of manufacturing in developed economies, which is closely related to whether the US's loose monetary policy and the fiscal policies of Europe and Japan can truly stimulate demand. I will place this after gold. If we look for some expectation differences based on the general consensus of "strong stocks, weak bonds, and mild inflation recovery," I would emphasize three points: First, rather than expecting another round of major stimulus on the demand side, I am more concerned about whether supply-side adjustments can truly drive inflation out of its low position; Second, with the US midterm elections coinciding with the rising discussion on AI, overseas volatility may significantly amplify, which could be a good timing for "passive adjustments and active opportunities" for Chinese assets; Third, regarding the RMB exchange rate as an asset, I am more optimistic than the market average expectation; it is both part of the macro narrative and an important allocation opportunity. Q11: If you had to summarize the biggest highlights of global macro and Chinese macro for next year in one sentence, what would you say? Duan Chao: If I had to summarize in one sentence, I would say: Globally, it is "unavoidable easing," while China is "new supply breaking through low inflation." For the world, especially for the US, whether it is fiscal pressure or the AI-driven economic model, it ultimately relies on the Federal Reserve's easing. The change of the Federal Reserve around May next year is a very critical observation point. Domestically, we have seen in the past few years that relying solely on demand stimulation is difficult to truly change inflation and perception. Moving forward, the key is to follow the path of "new supply," through supply-side adjustments, clearing inefficient capacity, and improving service quality, to help the economy and prices gradually emerge from low inflation. This is both what is currently being done and what I believe is the correct policy path