CICC: The Federal Reserve's "Unconventional" Interest Rate Cut has Started.

CICC released a research report stating that amid market fervor and concerns about an economic "recession", the Federal Reserve of the United States initiated a rate cut as scheduled. However, the extent of the rate cut was somewhat surprising to the market, as a 50bp rate cut at the beginning is not common in history. The reactions of various assets were mixed, with US treasuries, gold, the US dollar, and US stocks initially rising and then falling after the announcement of the rate cut. The market surged due to the 50bp rate cut at the beginning, but closed lower due to concerns about the subsequent path and economic outlook. Before the meeting, there was limited "incremental information" regarding the recession and rate cut, but the probability of the Federal Reserve making an initial 50bp rate cut increased significantly, intensifying concerns about the Fed's policy lagging behind the curve. At the same time, US stocks reached new highs, while US treasuries and gold rose, and the US dollar weakened, indicating a combination of "enough easing but not bad growth" in trading. Key points from the meeting: First rate cut of 50bp, two more rate cuts later in the year, totaling 250bp; Emphasis on no signs of recession, emphasis on a higher neutral interest rate. During this meeting, in addition to the "unconventional" rate cut of 50bp, the Federal Reserve also adjusted the "dot plot" of future rate cut expectations and economic data forecasts. Federal Reserve Chairman Powell emphasized the following key points in a news conference after the meeting regarding the subsequent rate cut path and economic outlook: 1) The 50bp rate cut is an unconventional start and partially exceeded market expectations. This 50bp rate cut aligns with the expectations of CME interest rate futures but exceeds the predictions of many Wall Street investment banks, making it an "unconventional" start. Historically, a 50bp rate cut only occurs at critical times in the economy or market, such as during the tech bubble in January 2001, the financial crisis in September 2007, and the COVID-19 pandemic in March 2020. 2) Two more rate cuts totaling 50bp are expected later in the year, with a total rate cut of 250bp, lower than the expectations of CME futures before the meeting. The updated "dot plot" predicts two more rate cuts totaling 50bp this year, 4 rate cuts of 100bp in 2025, and 2 rate cuts of 50bp in 2026. Combined with the 50bp rate cut at this meeting, the total rate cut amounts to 250bp, with the terminal rate ranging from 2.75-3%. This path is significantly lower than the slope indicated by CME interest rate futures trading, which suggests that the Federal Reserve will reach the 2.75-3% level by September 2025. This may explain the spike in US treasury rates after the market closes. 3) Powell emphasized that the 50bp rate cut cannot be linearly extrapolated as a new benchmark and believes that the neutral rate is significantly higher than it was before the pandemic. Considering that a 50bp rate cut may easily lead to concerns about the Fed's slow action, Powell repeatedly emphasized during the post-meeting news conference that this rate cut was not a rushed decision by the Federal Reserve, but a normal response to the current labor market environment. In order to dispel concerns about the linear extrapolation of the rate cut path, Powell also emphasized that there is no fixed rate path and that rate cuts can be accelerated, slowed down, or even paused based on the circumstances of each meeting. Additionally, Powell mentioned that the neutral rate is significantly higher than before the pandemic, indicating that the terminal rate will also remain at a higher level. In the economic data adjustments, the Federal Reserve raised the neutral rate from 0.8% to 0.9%. 4) Powell emphasized that he did not see any signs of a recession, the labor market has cooled down, but inflation issues have not been resolved. Since a 50bp rate cut may increase concerns about a potential economic recession, Powell also emphasized that there were no signs of an impending recession in the economy. A notable change in the economic data forecast was the upward revision of this year's unemployment rate forecast (from 4% to 4.4%, stabilizing at this level) and the downward revision of the PCE forecast to 2.3%. Overall, CICC believes that the Federal Reserve did recognize the weakness in the labor market, which is why they took the "unconventional" step of starting with a 50bp rate cut. This to some extent responded to market "demands". The Federal Reserve also seems to be trying to create an image of being "ahead of the market", showing that they can do more at any time but also wanting to avoid causing panic due to the pressure of a significant recession. The market's reaction shows that not rushing too much has indeed been effective, explaining the decline in safe-haven assets, but the pressure of economic recession has not yet completely convinced the market, explaining the pullback in risk assets as well. Rate cut path: Without pressure from a recession, a faster rate cut may lead to a slower path, and the easing effect is already beginning to show. Despite the initial 50bp rate cut, combined with optimistic guidance and current data, CICC still believes that a "soft landing" is the base case scenario. An interesting paradox is that a steeper initial slope may actually slow down the path of subsequent rate cuts because easing will take effect more quickly in rate-sensitive areas such as real estate. However, this also means that economic data released in the coming months will be crucial. As long as the data remains stable or shows improvement, this will further support the message the Federal Reserve is trying to convey of "faster rate cuts but no bad growth". At that point, risk assets will perform better, while the era of safe-haven assets might be coming to an end. In fact, although rate cuts have not yet been implemented, the easing effect is already starting to show, reflected in: 1) signs of both quantity and price increases in the real estate market. 2) Indirect financing: the percentage of banks tightening loan standards in the third quarter has significantly decreased, with the standards for residential loans even turning to relaxation (the percentage of banks tightening versus loosening loan standards is -1.9%). 3) Direct financing: investment grade and high-yield bond credit spreads are at historical lows of 14.6% and 32.7%, and with the sharp decline in benchmark interest rates, companies' financing costs have also rapidly decreased. How to trade the rate cut? Focus on easing trades rather than recession trades; gradually switch from denominator assets to numerator assets; short-term debt, real estate chains, and industrial metals are worth considering; Assess the impact on China to see if it can effectively transmit. Looking at the general patterns of previous rate cuts, CICC summarizes the performance of various assets in each rate cut cycle since the 1990s through a simple average method ("Rate Cut Trading Manual"). Generally speaking, easing trades have shown better performance.Before, the performance of denominator assets (such as US treasuries, gold, Russell 2000, and small-cap growth stocks represented by Hong Kong biotechnology) was good, while the performance of numerator assets (such as copper, US stocks, and cyclical sectors) was poor. However, after the interest rate cut, the easing effect gradually became evident, and numerator assets gradually began to outperform.However, the biggest problem with simply averaging historical experience is that it masks the differences in each interest rate cut cycle. Comparing historical experiences without distinguishing the macro environment not only makes no sense, but can also be misleading. The switch mentioned in the previous text from denominator assets to numerator assets, whether it occurs after the first interest rate cut or after the 10th, essentially depends on the number of interest rate cuts needed to match the degree of economic slowdown, rather than the interest rate cuts themselves. Otherwise, it is entirely possible to "do the opposite." For example, in the interest rate cut cycle of 2019, after the first interest rate cut, US bond yields gradually bottomed out, gold gradually peaked, and copper and US stocks gradually bottomed out and rebounded, thus achieving a switch. If one were to continue to increase exposure to long-term US bonds and gold at this point, it would be completely counterproductive. Currently, the unconventional interest rate cut starting with 50 basis points may still make the market worried about whether future growth will face greater pressure in the short term, so the future economic data will be crucial. If the data does not deteriorate significantly, or even improves as expected by CICC, in some interest-rate-sensitive sectors such as real estate, then it can signal to the market a combination of "sufficient interest rate cuts and no poor economy," leading to a new balance, and the market's focus may shift to recovery trades after interest rate cuts. Therefore, in the current environment, US bonds and gold may not yet disprove this expectation, and there may still be some holding opportunities but with limited short-term space. If subsequent data confirms that there is not much economic pressure, then these assets should be exited in a timely manner; on the other hand, what is more certain is short-term debts benefiting directly from the Fed's interest rate cuts and the gradual recovery of the real estate chain. For the Chinese market, the main impact of observing the Fed's interest rate cuts is how the peripheral easing effects will be transmitted, that is, how domestic policies will respond in this environment. Taking into account the constraints of the China-US interest rate differential and exchange rate, the Fed's interest rate cut will provide more easing opportunities and conditions for the domestic economy, which is needed in the current relatively weak growth environment and still high financing costs. Therefore, CICC believes that if domestic easing measures are stronger than the Fed's, it will provide a greater boost to the market. On the other hand, if the measures are limited, which is more likely under current constraints, then the impact of the Fed's interest rate cut on the Chinese market may be marginal and localized, as was the case in the 2019 interest rate cut cycle.