Zhongjin: How much rate cut is "enough"?

In the market's anticipation, the Federal Reserve opened a new round of interest rate cuts in an "unconventional" way by cutting rates by 50 basis points, officially ending the tightening cycle that had been in place since early 2022. The benefit of "unconventional" rate cuts is the quick response to address "potential but not yet visible" growth pressures, but the downside is that it can easily make the market worry that recession concerns are becoming a reality. After all, "unconventional" rate cuts are generally measures taken in extraordinary times, such as the internet bubble in 2001, the financial crisis in 2007, and the pandemic in 2020. Fortunately, Federal Reserve Chair Powell emphasized that there are no signs of recession, the interest rates are currently higher than historical levels, and the dot plot path is more gradual than market expectations, creating an image of being "ahead of the market", able to do more at any time, but not forced to do more due to recession pressures ("Fed's Unconventional Rate Cut Kickoff"). The market did not see the 50 basis point rate cut as a desperate move after a significant increase in recession pressures, as asset performance showed a combination of "ample accommodation but not bad growth", with risk assets, especially growth styles, leading the way. Therefore, the next few economic data points will be crucial, as they will directly determine the rate cut path for the remaining two meetings this year, as well as the balance between recession trades (US Treasuries, gold), accommodation trades (both stocks and bonds rising, growth stocks leading), and recovery trades (late cycle leaders, such as real estate and industrial metals). After the 50 basis point rate cut in September, the Federal Reserve's dot plot shows a potential further 50 basis points cut this year and a total of 200 basis points by 2026, which is in stark contrast to CME futures' expectations of a 75 basis point cut this year and a 200 basis point cut in September 2025, the latter being more aggressive. So, how many more rate cuts does the Fed need to make, and how much is enough? Where is the endpoint of interest rates? Answering these questions is essentially about answering when monetary policy will move out of the "restrictive" range, and when it will begin to boost growth. When will monetary policy move out of the "restrictive" range? The household sector has already entered a loose state, while the tightness on the corporate sector and the overall economy is rapidly narrowing. Measuring whether monetary policy is "restrictive" is not about looking at its absolute level, but comparing it to the return on investment in the economy, i.e., comparing it to the level of interest rates that different sectors of the economy can withstand. This rate cut cycle may produce results faster than expected and based on normal historical experience, similar to why it took a long time for rate hikes to have an effect on inflation, possibly because the return on investment in the economy has risen significantly (as Powell mentioned, the "neutral interest rate" is significantly higher than pre-pandemic levels). In the first quarter of this year, the private sector in the US was able to expand unexpectedly even before rate cuts, partly because monetary policy was not far from the edge of the return on investment boundary and could quickly move into a loose territory; and also because financing costs in various sectors are based on the 10-year US Treasury rates and had already started to fall due to rate cut expectations without waiting for actual rate cuts. From this perspective, after the recent rate cut expectations and the rapid decline in US Treasury yields, we note that the "restrictiveness" of monetary policy on the household side has been largely removed, and the constraints on the corporate sector and the overall economy have also rapidly narrowed. Specifically, Household sector: With rate cut expectations and recession concerns driving a significant drop in financing costs, the sector has shifted to loose. In the household credit structure, housing mortgages account for 75%. Therefore, we use the mortgage interest rate and rental yield as measures of the household sector's financing costs and return on investment. The 30-year mortgage rate has followed a similar trend to the 10-year US Treasury yields, with rate cut expectations leading to a rapid decline in the 30-year mortgage rate, which has now fallen to 6.1% (as of September 19), significantly lower than the rental yield of around 6.8%. At the same time, banks' residential mortgage lending standards have also become relaxed in the third quarter (the proportion of banks tightening-relaxing standards is -1.9%). Corporate sector: The decline in financing costs and the increase in return on investment have removed restrictions for large enterprises and reduced the tightness for small and medium enterprises from 330 basis points to 250 basis points. The corporate sector's financing channels include both indirect financing (business loans accounting for 14%) and direct financing (corporate bonds accounting for 40%). Large enterprises tend to issue bonds, while small enterprises rely more on bank loans. In terms of financing costs, high yield and investment-grade credit spreads have fallen from their highs in the fourth quarter of 2023 to 3.24 percentage points and 1.25 percentage points, respectively, currently at 30% and 15% historical percentiles. Coupled with the significant decline in benchmark rates, the cost of direct financing has quickly fallen, with high yield yields falling by 260 basis points (9.6% vs. 7%), and investment-grade bond yields falling by 163 basis points (6.6% vs. 5%). Indirect financing through business loans has also seen a significant loosening of standards, with the added financing cost for small and medium enterprises dropping from 9% to 8.6%. In comparison, the return on investment has increased. The ROIC of the S&P 500 index has consistently been higher than the credit spreads since the current round of rate hikes began, and is still modestly rising, with the difference between the ROIC and credit spreads further widening, indicating that the financing of large enterprises has not been restricted. The ROIC of the non-financial corporate sector showed signs of improvement after a two-quarter decline, rising from 5.6% in the second quarter to 6.1%, and narrowing the gap with the added financing cost for small and medium enterprises from 330 basis points in the first quarter to 250 basis points. Overall economy: The gap between real interest rates and natural interest rates has narrowed to less than 70 basis points. For the overall economy, the gap between real interest rates and natural interest rates (the level of real interest rates when inflation and output gaps are balanced) can be used to gauge the degree of restraint and promotion of monetary policy on the economy. In terms of financing costs, since the peak in April, rate cut expectations and concerns about growth have driven real interest rates to fall continuously from 2.3% to 1.6%. The natural interest rate, which reflects the return on investment, has also started to rise, with different models providing different estimates. A relatively high-frequency and simple estimation method is to subtract the 2% PCE target value from the long-term rate in the Federal Reserve's dot plot, which has risen to 0.9% since the second quarter (long-term rates in March, June, and September were 2.7%, 2.The difference between the two decreased from 117bp in the first quarter to 70bp, reflecting a slight relaxation in the overall economic suppression level. If measured at the levels calculated by the New York Fed and the Richmond Fed, this difference may be even narrower.In addition, financial conditions have also eased to the most accommodative levels since the rate hike in 2022. A broader range of financial conditions can also serve as a supplementary indicator to assist in judgement (Threshold for Fed Rate Cuts), consisting of long-term interest rates, short-term interest rates, credit spreads, US stocks, and the US dollar. Due to the large short-term fluctuations in US stocks, the impact on short-term changes in financial conditions is also more obvious, which is also the main reason why US stocks have been driving continuously accommodative financial conditions this year. Financial conditions, as a high-frequency indicator, lead economic surprise indices by 2 to 3 months, and the recent improvement in economic surprise indices is the result of the relaxation of financial conditions in July; leading the inflation surprise index by 1 month, the tightening of financial conditions in August is reflected in the recent weakness in the inflation surprise index. Where is the end point of rate cuts and interest rates? A 3.5% long-term bond rate can already boost demand, and further decreases can activate more of the existing real estate market. As we discussed in the previous text, the overall economic and macro sector easing effects currently taking place are judged against the contrast of "new" financing costs and investment returns to determine whether marginal improvements have occurred. However, if financing costs fall further below the level of "existing" costs, the interest payment pressure in various sectors will be significantly eased, which in turn stimulates improvement in demand. Assuming other conditions remain unchanged, and relying solely on the decline in financing costs to deduce the level of US bond yields. Household sector: A 3.2% rate can further stimulate existing demand. As analyzed earlier, the current 3.7% US bond rate has already driven 30-year mortgage rates below rental yields, stimulating marginal demand improvement, but more for attracting first-time home buyers. Merely equalizing investment returns and financing costs cannot fundamentally solve the shortage of existing homes. The willingness of existing homeowners locked in at relatively low interest rates to sell is limited, leading to low inventory levels, high housing prices, and thus restraining the purchasing power of residents. If new mortgage rates are lower than existing rates, this can further stimulate residential demand. By disaggregating the structure of existing mortgage loans, it is found that only 13% of mortgage rates are above 6%, therefore the current financing cost of 6.1% is not entirely attractive and cannot effectively address the mismatch between supply and demand. Moreover, the overspending of housing demand after the pandemic has led to a weak willingness for residents to move, and under the condition of maintaining the original interest rates, only 25% of those inclined to switch will do so. If mortgage rates fall to 5%, the maximum percentage of potential listed homeowners can reach 22%, or to some extent, increase supply. The 30-year mortgage rate and the 10-year US bond rate do not change one-to-one, and their average spread widened after the pandemic due to spread inversion and Federal Reserve balance sheet contraction of MBS. Assuming a return to the average spread level of 180bp, corresponding to a 10-year US bond rate of around 3.2%. Enterprise sector: Current interest rate levels have already improved existing interest payment pressures. Indirect business loans have a lag in disclosing existing interest rates, so the changes brought about by the fall of US bond rates and Fed rate cuts in the third quarter have not been published. The second-quarter existing level remains stable from the first quarter at 6.7%, with ROIC increasing from 5.6% in the first quarter to 6.1%, narrowing the gap between the two from 1.1ppt to 0.6ppt. As business loan rates are highly correlated with the 10-year US bond rate, our calculations show that the current 3.6~3.7% bond rate corresponds to an effective business loan rate of 5.3~5.5%, with the premise of growth recovery supporting ROIC (6.1% in the second quarter), the overall enterprise-side existing financing costs in the third quarter may have already fallen below the investment return rate. Overall economy: 3.5%~3.6% can basically eliminate the difference between real interest rates and natural interest rates. As mentioned earlier, different models project different natural interest rates, with the LW model predicting 1.22%, the HLW model predicting 0.74%, the Richmond Fed predicting 2.6%, the Federal Reserve predicting 0.9%, and the average being about 1.4%. Currently, there is still a difference of 10bp~20bp between real and natural interest rates. If this difference is eliminated, assuming inflation expectations remain unchanged, real interest rates may fall to 1.4%~1.5%, corresponding to a 10-year US bond rate of around 3.5%~3.6%. What are the implications for assets? Loose trading rather than recession trading, gradually switching from denominator assets to numerator assets; short-term debt, real estate chains, and industrial metals may warrant attention. Based on asset experiences during rate-cut cycles since the 1990s, the general rule shows that denominator assets perform better before rate cuts (such as US bonds, gold, small-cap growth stocks represented by the Russell 2000 and Hong Kong biotech stocks), and after rate cuts, the loosening effects gradually appear, with numerator assets beginning to outperform (such as copper, US stocks, and cyclical sectors) (Rate Cut Trading Manual). However, each cycle is different, with differences in macro environments leading to different trends in assets and trading logic, such as in the rate-cut cycle of 2019. After the first rate cut, US bond rates gradually bottomed out, gold gradually peaked, and copper and US stocks gradually rebounded, resulting in a switch. Therefore, with a bias towards 2019 as the benchmark scenario, it is suggested that investors should "think and act in reverse" in the current stage. Currently, the unconventional rate cut starting at 50bps may still cause market concerns in the short term about whether future growth will face greater pressures. Therefore, the importance of future economic data is crucial, as it will determine the tilt between recession trading (US bonds and gold), loose trading (bullish on stocks and bonds, growth stocks leading), and recovery trading (leading in the late cycle, such as real estate and industrial metals). If data does not worsen significantly, and even as we expect, in some rate-sensitive areas such as real estate, there may be some improvement, it will convey to the market a combination of "sufficient rate cuts and a not-so-bad economy", achieving a new balance, and the subsequent market trend may shift towards recovery trading after the rate cut. Therefore, in the current environment, US bonds and gold still cannot disprove this expectation, but may still have some holding opportunities, albeit limited in the short term. If subsequent data confirms that there is not much economic pressure, then these assets should be exited in a timely manner. In contrast, more certain beneficiaries are short-term debts directly benefiting from Fed rate cuts, gradually recovering real estate chains (even driving Chinese export chains), and copper.Gradually focusing, but still slightly skewed to the left side at the moment, need to wait for several more data for verification ("a new approach to rate cuts trading").This article is reprinted from Zhongjin Dianjing, GMTEight editor: Chen Wenfang.