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Since the beginning of August, economic data such as non-farm payrolls and PMI have weakened successively, triggering recession concerns. In addition, the reversal of the yen carry trade has amplified the sharp fluctuations in assets, and the expectation of the Fed's interest rate cut has suddenly risen to 50bp for many consecutive times, and even to the point where an emergency meeting is required to cut interest rates. After a few weeks of digestion, the market has largely recovered its lost ground, which is consistent with our judgment that although liquidity has tightened, it is not unsolvable ("New Issues in Carry Trades and Liquidity Shocks"). The expectation of interest rate cuts has also swung back from 50bp to the "normal level" of 25bp, but the market's recession concerns have not completely dissipated. In fact, since the beginning of this year, expectations for interest rate cuts have swung many times and violently, and we have always insisted on“Rates can be cut, but not by much”Judgment ("Global Market Outlook for the Second Half of 2024: Easing is Halfway Through").

Although the expectation of interest rate cut is strong and has been brewing for a long time, the clear hint from Fed Chairman Powell at the Jackson Hole meeting[1] that interest rate cut will be initiated still attracted widespread attention. From the perspective of assets,The interest rate cut cycle is finally about to begin. Does it mean that the current trading will be further strengthened? Or is it likely to come to an end? In response to the common "misunderstandings" in the market, we provide some new ideas and suggest that thinking slightly in the opposite direction, or even doing the opposite, may have a better effect.

1. Timing of interest rate cut: September interest rate cut is basically confirmed, and the Fed's focus shifts from inflation to employment

Powell's remarks were almost equivalent to an early "official announcement" of a September interest rate cut, highlighting the shift in focus to the job market.The Fed's hawkish stance in the past was mainly due to inflation expectations, and concerns about the risk of secondary inflation if interest rate cuts were traded in advance. At the Jackson Hole meeting, Powell changed the policy goal statement with a higher inflation weight, using the words "lower inflation risk" and "rising employment risk", pointing out that they are concerned about both risks. Powell showed stronger confidence in inflation, saying that inflation expectations are well anchored and inflation is much closer to our objective.These statements can basically be seen as a declaration of victory in the fight against inflation.In contrast, Powell devoted more time to discussing employment than inflation in this speech, especially compared to the 2023 speech, which was almost entirely devoted to discussing inflation. Powell believes that the job market has cooled considerably from overheating, and it is difficult for the job market to cause inflation to rise again.

The market has now fully factored in a September rate cut.We pointed out in the July FOMC comments ("September rate cut is getting closer"), and the minutes after the July FOMC meeting also showed that the vast majority of participants have expressed support for a September rate cut. The Jackson Hole meeting gave a clearer statement that the time has come for policy to adjust. Before the meeting, the September rate cut was a foregone conclusion. After the meeting, CME interest rate futures included a 100% probability of a September rate cut, including a 76% probability of a 25bp rate cut and a 24% probability of a 50bp rate cut.

Chart: Market expectations of a September rate cut have reached 100% probability

Source: CME, CICC Research Department

2. Rate cut path: The magnitude and path are more important, but 50bp is still a "small probability"

Compared to the interest rate cut itself, which is already clear and fully factored in,The path of interest rate cuts is the focus of market competition, because after expectations are fully factored in, 25bp is unlikely to provide a new catalyst(“How much interest rate cut expectations are currently factored into various assets?”). Based on the view that fundamentals are slowing down but not in deep recession,We maintain our baseline view that “interest rate cuts are possible, but not by much”, and a 50bp rate cut is still a “small probability” at present.Unless the next non-farm data is significantly lower than expected. In this speech, Powell did not give a clear path, saying that the pace of interest rate cuts depends on incoming data, evolving outlook and balance of risks, but Powell also said that he did not think the rise in unemployment was the result of elevated layoffs, and believed that it was mainly due to a substantial increase in the supply of workers and a slowdown in hiring, and he was not overly worried.

Since the beginning of this year, expectations for interest rate cuts have fluctuated several times and significantly.For example, when the market fell sharply two weeks ago, the market expected a rate cut starting at 50bp, or even an emergency rate cut; two months ago, affected by the "Trump deal" and concerns about re-inflation, it was expected that there would be a maximum of two rate cuts this year; three months ago, due to the resilience of economic data and the continued highs in copper prices under the expectation of the start of a global investment cycle, the market even expected an interest rate hike rather than a cut; at the beginning of half a year ago, the market expected 6 to 8 sharp interest rate cuts within the year.This also fully demonstrates that simple linear extrapolation at any point in time may be completely opposite.

Chart: When the market crashed 2 weeks ago, the market expected an emergency meeting in September to cut interest rates by 50bp

Source: CME, CICC Research Department

Chart: 2 months ago, due to Trump and the reflation trade, the expectation was that at most 2 rate cuts would be made this year

Source: CME, CICC Research Department

The swing in expectations makes asset allocation more difficult and requires an anchor point.Based on the new idea that interest rate cuts are to reduce the financing costs of various departments and links to below the return on investment,We estimate that the central value of 10-year US Treasury bonds is 4%, which means that the Fed can solve the problem by cutting interest rates 4-5 times (about 100bp) in this round of interest rate cuts.Our view is also basically confirmed by the repeated swings in the interest rate cut expectations this year (New Ideas for Calculating U.S. Treasury Bond Interest Rates). Of course, policy changes after the election, such as fiscal stimulus and inflationary policies such as tariffs and immigration, may change the future path.

Chart: Considering the inverted interest rate spread and financial risks, the Fed can achieve this by cutting interest rates 4-5 times (100bp)

Source: Bloomberg, Federal Reserve, CICC Research

Chart: The swing in expectations makes asset allocation more difficult and requires an anchor point

Source: Bloomberg, CICC Research

3. Interest rate cuts and fundamentals: “Recession” does not mean that interest rates do not need to be cut much. In turn, interest rate cuts are sufficient to support growth

When talking about the impact of interest rate cuts, a common "misunderstanding" in the market is to take interest rate cuts as the starting point and deduce that interest rate cuts often correspond to judgments of growth and market pressure. However, doing so is equivalent to reversing cause and effect.The correct approach should be to first determine the economic cycle and then determine the extent of the interest rate cut and its impact.After all, interest rate cuts were intended to address growth problems at the time.

also,We also do not recommend simply using the word "recession" to describe the economic situation, because "recession" does not have a strict definition.The U.S. Bureau of Economic Analysis (NBER) is very slow in identifying recessions. There is a fundamental difference between a simple slowdown and a recession. The former can recover quickly after the Federal Reserve adjusts financial conditions. This is reflected in assets, such as the U.S. stock market did not fall before and after the interest rate cut in 1995. The U.S. stock market had a phased correction in 2019 but quickly regained its upward momentum. On the contrary, if it is a deep recession, the Federal Reserve's large-scale interest rate cuts may not be useful. Sometimes fiscal cooperation is needed, such as the 2008 financial crisis ("The Basis for Judging Recession and Historical Experience").Therefore, the excessive use of "recession" has no practical use except to increase emotional and narrative pessimism. Instead, it will lead to excessive pessimism about risky assets and excessive optimism about safe-haven assets.

When judging the economic position, it is not an effective strategy to discuss one or two specific data too closely or rely on so-called leading indicators.On the one hand, when there is a gap between growth slowdown and monetary easing, data often swings back and forth, and both pessimists and optimists can find their own reasons, making it impossible to see the full picture. For example, the recent manufacturing PMI continued to decline below expectations, but the service industry PMI continued to improve; employment data slowed down, but real estate data rebounded again after 5 months.

Chart: When growth slows and monetary easing is in transition, data often swings back and forth

Source: Haver, CICC Research Department

on the other hand,The so-called leading indicators have very limited significance in practice. They can neither answer when a recession will occur after being triggered nor the extent of the recession.For example, 1) Two consecutive quarters of negative GDP growth is an empirical standard for a "technical recession", which has already occurred in the first and second quarters of 2023. 2) The inverted U.S. Treasury yield curve appeared in early 2022 and has lasted for more than two years, and the economy remains resilient. 3) The Sahm Rule was recently triggered, which is also the source of rising concerns about this round of recession, but in his latest interview[2], Sahm also said that this time may be different, such as the impact of immigration, whether it is necessary to consider the starting point of the increase in unemployment rate, rather than just the magnitude. 4) The Bank of Japan raised interest rates again last week. According to market experience, this is a sign of recession. However, this is an a posteriori rule and lacks a necessary connection. It is basically equivalent to judging that the Fed's interest rate hikes often lead to recessions.

Chart: Sam's rule shows that the current rise in unemployment has triggered recession conditions

Source: Haver, CICC Research Department

Chart: The Bank of Japan raised interest rates again, which is a sign of recession according to market experience

Source: Bloomberg, CICC Research

In the current environment, if recession means slower growth, we are fine with that.The U.S. economy is indeed in a slowdown channel, which is why the Federal Reserve cut interest rates, but on the other hand, it also means that there is no need to worry too much;But if the concern is about a deep recession, we don't think it applies to the current situation.As discussed above, our judgment is not based on one or two data or leading models, but is more based on the characteristics and particularities of this cycle in the United States:1) The seemingly high interest rates actually have limited impact on the economy because the actual interest rates are not high, and more importantly, the investment returns in each link are also not low.This is why the downward trend in market interest rates driven by the expectation of interest rate cuts at the beginning of the year can also promote the repair of the real estate cycle. Recently, this effect has begun to manifest itself again. After the 30-year mortgage rate followed the 10-year US Treasury bond to fall to 6.5%, it was once again lower than the average rental return rate of 7%. In July, US existing and new home sales rebounded again after a lapse of 5 months. US existing home sales grew for the first time in 5 months. The leading new home sales also achieved a month-on-month growth of 10% in July, which greatly exceeded market expectations (739,000 households, expected 623,000 households). At present, the financial conditions index has fallen to a new low again. Based on historical experience, it may gradually reflect the pull effect on interest rate sensitive sectors in the next few months.

Chart: The seemingly high interest rate actually has limited impact on the economy because the actual interest rate is not high and the return on investment in each link is also not low.

Source: Haver, CICC Research Department

Chart: New and existing home sales recovered after 30-year U.S. mortgage rates fell to 6.5% from 7.2% in May

Source: Bloomberg, Wind, CICC Research Department

2) The misalignment of different links creates a hedge of gains and losses.Service consumption remains resilient because the consumption capacity of the household sector is insensitive to rising interest rates (90% are fixed-rate mortgages), but it will gradually slow down as the job market cools, while real estate and investment, which have been at the bottom of the cycle for two years, are expected to recover moderately as interest rates are cut and downward.

Chart: The misalignment of different links creates a hedge of gains and losses

Source: CICC Research Department

Therefore, instead of worrying about the word recession itself, we should pay more attention to the depth of the economic downturn and the effectiveness of monetary easing.The Fed also showed a positive attitude in responding to economic risks this time. Powell said that there is ample room for monetary policy operations and that he does not seek to further cool the labor market. He also used the phrase "will do everything we can to support" to express support for maintaining a strong labor market, showing a positive attitude in policy response.In summary, the fact that growth pressure is not great means that the Fed does not need to cut interest rates by a lot, which in turn can support growth again by adjusting financing costs.

4. Trading strategy: moderately think and act in the opposite way; the denominator assets should be “fighting and retreating”, and the numerator assets should be gradually deployed. The Chinese market needs its own policy coordination

When judging the impact on assets and formulating trading strategies, just like judging the relationship between interest rate cuts and fundamentals, we must also start from the economic cycle. Interest rate cuts at different stages are not only incomparable, but may even be completely opposite.Therefore, over-reliance on the "average law" of previous interest rate cut cycles has little reference value and may even be misleading.Judging from the average rule alone, before the rate cut, "denominator assets", such as US bonds, gold, Russell 2000 and Hong Kong biotech growth stocks, are more elastic, while "numerator assets" such as stocks, especially cyclical value, industrial metals, and real estate chains are often under pressure, otherwise there is no need to cut interest rates. After the rate cut, these assets gradually recover and outperform ("Interest Rate Cut Trading Manual"). However, this simple "average" rule is almost meaningless in practice, because the "numerator asset" may be intervened after a certain extent of correction, and the switching time after the rate cut may be very different in different rate cut cycles.

Chart: Historical pattern: before the rate cut, denominator assets such as US bonds, gold, and growth sectors are better; after the rate cut, numerator assets such as industrial metals, crude oil and the US dollar are better

Source: Bloomberg, CICC Research

Chart: However, the macroeconomic background of each rate cut is different, and the intervention after the "molecular asset" has a certain degree of correction, as well as the switching time after the rate cut are also different.

Source: Bloomberg, CICC Research

Therefore, we should first determine whether the current situation is more similar to the soft landings of 1995 and 2019, or the deep recessions of 2001 and 2008.With this judgment, the extent of the interest rate cut and the impact on assets after the interest rate cut will become clear.We prefer to think that 2019 is a more comparable benchmark scenario, which is why we recommend that when trading on rate cuts, you need to think and act in the opposite way.During the interest rate cut cycle in 2019, long-term U.S. Treasury bond yields bottomed out and gold peaked after the first rate cut, while copper and U.S. stocks gradually rebounded, rather than waiting until the end of the rate cut cycle.

This time may be similar.Denominator assets are the main trading opportunities before interest rate cuts.The most elastic, recent performance has fully proved this point, but due to the full inclusion of expectations and the limited extent of interest rate cuts,When the interest rate cut is realized, it may be time to gradually take profits and retreat, rather than adding to positions aggressively.on the contrary,Those assets that benefit from the interest rate cut can choose to increase their positions appropriately.The recent rebound in copper prices and the gradual recovery in US real estate data are typical examples.

Chart: We should first determine whether the economic fundamentals are a soft landing similar to 1995 and 2019, or a deep recession like 2001 and 2008

Source: Bloomberg, CICC Research

Chart: After the first rate cut in 2019, long-term US Treasury bond rates bottomed out, gold peaked, and copper and US stocks gradually rebounded, rather than waiting until the rate cut cycle ended.

Source: Bloomberg, CICC Research

Specifically, 1) the 10-year US Treasury bond rate of 3.8% is fully factored into expectations. As the rate cut approaches, we can pay more attention to opportunities under short-term bonds and steepening curves; 2) The gold price of $2,500/ounce is also the central position given by our fundamental model, unless non-fundamental factors such as geopolitical situation and central bank gold purchases increase again; 3) The US stock market has changed from "no fall, no buy" to "if it falls too much, you can buy it back". 4) The real estate chain and industrial metals that benefit from the rate cut can be gradually paid attention to. We calculate the degree of "preemptive" in the expectation of rate cuts by assets, interest rate futures> copper> US Treasury bonds> gold> US stocks ("How much interest rate cut expectations are currently factored into various assets?").

Chart: The 3.8% 10-year US Treasury bond rate is well-priced into expectations. As the rate cut approaches, we can pay more attention to opportunities in short-term bonds and steepening curves.

Source: Bloomberg, CICC Research

Chart: Based on the annual real interest rate of 1-1.5% and the USD 102-106 range, the central price of gold may be around USD 2,500/ounce

Source: Bloomberg, CICC Research

Chart: Measured by the extent to which assets factor in the expectation of a rate cut, interest rate futures > copper > US bonds > gold > US stocks

Note: Data as of August 24, 2024

Source: Bloomberg, CICC Research

For the Chinese market, the significance of the Fed's interest rate cut is to provide room for internal policy operations, which is the core factor that determines the trends of the A-share and Hong Kong stock markets, rather than the Fed's interest rate cut itself.Still taking the 2019 interest rate cut cycle as an example, the sharp rebound of A-shares and Hong Kong stocks was precisely in January-March in early 2019 when Powell announced the end of interest rate hikes, rather than in July-September when the official interest rate cut was made. The reason is that when Powell announced the end of interest rate hikes in early 2019, China also decided to cut the reserve requirement ratio, which formed a resonance between the inside and the outside. On the contrary, the policy after April reiterated the "monetary policy gate" which was the opposite of the Fed's easing. Therefore, even if the Fed officially cut interest rates from July to September, A-shares and Hong Kong stocks maintained a volatile pattern as a whole, which more reflected the fundamentals of the weak recovery in China and the tight policy, rather than the Fed's interest rate cut. Overseas funds also flowed out during this period.

Therefore, it is not difficult to see that the future Fed rate cuts provide a window for further easing of domestic policies.If the easing can be stronger than that of the Federal Reserve by then (the difference between China's actual interest rate and natural interest rate is higher than that of the United States), it can provide a greater boost to the market, especially Hong Kong stocks; on the contrary, if the easing is also the same but the intensity is the same or even weaker, it will not change the overall volatile market structure.With this in mind, based on our judgment of the current environment and realistic constraints, for the Chinese market,We think the impact of the Fed’s rate cut may be smaller than the election.As far as interest rate cuts are concerned alone, Hong Kong stocks are more resilient than A-shares, and long-term assets such as semiconductors, automobiles (including new energy), media entertainment, software, and biotechnology are even more resilient.

Chart: For the Chinese market, the significance of the Fed's interest rate cut is to provide room for internal policy operations, which is the core factor that determines the trend of the A-share and Hong Kong stock markets

Source: Bloomberg, CICC Research

Chart: When interest rates were cut in 2019, overseas funds also flowed out

Source: Bloomberg, EPFR, CICC Research

Chart: Growth sectors such as semiconductors, automobiles (including new energy), media and entertainment, software, and biotechnology may have higher elasticity

Source: Wind, CICC Research Department

[1]https://www.federalreserve.gov/newsevents/speech/powell20240823a.htm

[2]https://www.barrons.com/articles/sahm-rule-recession-4b114b90

Source

Article Source

This article is excerpted from: "New Ideas for Interest Rate Cut Trading" published on August 25, 2024

Gang Liu, CFA Analyst SAC Certificate No.: S0080512030003 SFC CE Ref: AVH867

Li Yujie Analyst SAC License No.: S0080523030005 SFC CE Ref: BRG962