CICC: How will various assets be affected by the expected interest rate cut?

The unexpected hawkish rate cut by the December FOMC caused significant fluctuations in various assets. This was partly due to the fact that the meeting itself was indeed more hawkish than the market expected, and also because various assets were already in a state of high expectations or even exuberance. In fact, since the results of the November elections, various assets have been influenced by a mix of Trump trade and rate cut expectations, experiencing fluctuations and divergences. For example, while US Treasury bonds have been rising recently, the dollar has strengthened, the Dow has experienced a continuous 10-day decline, marking the longest consecutive drop since 1978, but the Nasdaq continues to hit new highs. After the hawkish rate cut, rate cut trades temporarily became the dominant logic, leading to spikes in US Treasury yields and the dollar, and significant drops in US stocks and gold. However, with the upcoming inauguration of Trump on January 20, his policy impact is bound to "make a comeback", especially since we believe that the current hawkish stance of the Federal Reserve is not necessarily a bad thing for the US economy and the stock market, and there is no need to go from the extreme of a "substantial rate cut" in September to the other extreme of "unable to cut rates" now. Therefore, understanding the current expectations factored into various assets, the extent of rate cut expectations, and other policy expectations is crucial as a reference for judging the subsequent policy impacts. Rate cut expectations: Most assets are factoring in expectations that are more hawkish than the Federal Reserve, providing opportunities for contrarian trades. The December FOMC meeting put an end to the rate cut path for 2024, but not for the entire rate cut cycle. A year ago, at the December 2023 FOMC meeting, Powell unexpectedly turned dovish, mentioning that "rate cuts are on the horizon." At that time, CME rate futures expected a rate cut of up to 150 basis points for the year, bringing rates down to 3.75%-4%. However, a year later, current rates are not only 50 basis points higher than expected at the end of last year, but the future rate cut space has also been compressed. In fact, this year, there have been several swings from one extreme to another in rate cut expectations. In September, the market even expected a 50 basis point rate cut to begin a total of 200 basis points of cuts due to recession fears triggered by the "SAM rule", which now seems overly pessimistic and possibly a low point that can't be reached again. This once again reminds us that linear extrapolation of expectations from any extreme position is likely to be inaccurate. The Federal Reserve is not unable to cut rates anymore; the current pause is because: on the one hand, in this cycle of a "soft landing" or even no landing at all, not many rate cuts are needed, especially with financing costs and investment returns already very close, too rapid rate cuts may do more harm than good; on the other hand, many of Trump's policies will indeed change future inflation and inflation paths, requiring time to observe. Therefore, contrary to market concerns, the Fed's way of presenting a surplus of options in advance is not necessarily a bad thing; it allows more room for maneuvering, and now being "hawkish" will pave the way for future cuts. This also provides assets with opportunities for contrarian trades after overadjustment. We estimate that the rate cut expectations factored into various assets are more hawkish than the Federal Reserve's dot plot, and even higher than CME rate futures expectations. Calculating with a 25 basis point rate cut as one cut, the rate cut expectations factored into various assets for the future year are: US Treasury bonds (0.4 times) < copper (0.5 times) < CME futures (1 time) < gold (1.4 times) < Nasdaq (1.9 times) < Dow Jones (2 times) < Federal Reserve dot plot (2 times) < S&P 500 (2.3 times). US Treasury bonds: Short-term rates imply a rate cut of less than one time. The implied rate expectation for 1-year US Treasury bonds is 4.3%, significantly higher than our calculated reasonable central value of 3.5% (corresponding to another 50-75 basis point rate cut). 1) Monetary policy returning to neutral: The average natural rate calculated by the New York Fed, the San Francisco Fed, and the Federal Reserve dot plot is 1.4%, with a 2025 PCE expected to be 2.1%-2.5%. Therefore, the nominal neutral rate is 3.5%-3.8%, and it would be appropriate to cut rates another 2-3 times based on this. 2) Taylor rule: Assuming an unemployment rate and inflation level of 4.3% and 2.5% respectively at the end of 2025, under the equal-weighted Taylor rule, the appropriate federal funds rate would be 3.2%, with the upside risk of inflation possibly leading to a smaller actual rate cut by the Federal Reserve. Long-term bond rates have already surpassed our calculated levels. The current 10-year US Treasury bond yield is 4.6%, with the rate expectation at 4.16% and a term premium of 0.4%. We calculate that: 1) Rate expectation: It is the average of future short-term rates. Assuming that the short-term rates for 2024, 2025, and 2026 are in line with the Federal Reserve dot plot projections, with the short-term rates for the next 7 years around 3.5% (1.4% natural rate + about 2.1% long-term inflation central), the reasonable level for the 10-year US Treasury bond yield is 3.6%; 2) Term premium: Assuming the term premium will turn positive after the balance sheet reduction, within a range of 30 to 50 basis points. Adding these together, the central value for the 10-year US Treasury bond yield is 3.9% to 4.1%. Copper: Implies a rate cut of less than one for the coming year, lower than CME futures. Using inflation expectations, the relationship between the dollar and copper prices, we calculate the implied inflatioRoughly speaking, this is similar to the guidance of the Fed's dot plot, with the S&P 500, Dow Jones, and Nasdaq indices ranked in order of magnitude.Overall, based on our calculations, the Federal Reserve could cut interest rates 2-3 more times as a benchmark, so the CME futures' expectation of only 1 cut seems a bit overly pessimistic. Based on this standard, the expectations included in the US stock market are relatively reasonable; the expectations included in US bond rates are clearly too low and could provide short-term trading opportunities; the expectations included in copper prices for rate cuts are also too low, therefore there is room for an increase; gold, only from the perspective of rate cut expectations, is not considered excessive, but it also includes other risks compensations, so it is not considered cheap. Policy expectations: debt ceiling for US bonds, policy risk for gold, tariffs for the stock market In addition to the rate cut expectations, the debt ceiling and Trump's fiscal policy since taking office for US bonds, policy and geopolitical risks for gold, and tariff paths for the stock market may also have different impacts. Specifically, The upward movement of long-term US bonds mainly reflects supply factors and growth expectations, rather than concerns about rate hikes and inflation expectations. The 10-year US bond yield has risen from a low of 4.15% on December 6 to 4.56%, an increase of nearly 40 basis points, with 37 basis points coming from term premiums, while interest rate expectations reflecting concerns about rate hikes have remained basically unchanged; similarly, when decomposing based on real interest rates and inflation expectations, of the 37 basis points, 37 basis points come from real interest rates and inflation expectations contribute very little. The reason for this may be that the US Treasury expects to issue a high amount of US bonds in the first quarter of 2025, reaching 823 billion US dollars, the highest since the third quarter of 2023, which may explain the increase in term premiums. This shows that the recent rise in long-term US bond yields is due to supply factors rather than concerns about rate hikes, to growth expectations rather than inflation expectations, which also explains why US bond yields have risen since December, but the stock market has not responded much. Looking ahead, the debt ceiling will affect the short-term trend of US bonds, but if resolved smoothly, it will provide trading opportunities. The prolonged delay in resolving the debt ceiling means that the Treasury Department needs to use cash from the TGA account to temporarily maneuver, which will increase the supply pressure on the debt ceiling to compensate for the TGA after the debt ceiling is resolved. Currently, the term premium in the 10-year US bonds is around 50 basis points, which, from absolute levels, is close to the high point corresponding to the peak issuance of bonds in October last year, but from the bottom to the top, the increase (73 basis points) is still less than the increase seen after the resolution of the debt ceiling in 2023 when the Treasury Department issued a large amount of debt (140 basis points). In the future, the debt ceiling that takes effect on January 1 is worth paying attention to. If a prolonged delay in solving the issue could lead to supply pressure from future debt issuances to compensate for the TGA, coupled with the fiscal expenditure expectations of the new government taking office, may increase the short-term likelihood of an increase in term premiums. But if negotiations are resolved smoothly, the supply fluctuations will smooth out, without causing a sudden increase in supply. Given that the Republicans control both houses of Congress in 2025, we lean towards the latter. Therefore, the current US bond yield of 4.6% is seen as relatively high from the perspective of rate cut expectations and supply factors (our calculated range of fair values is 3.9-4.1%), and will provide temporary trading opportunities. In the short term, pay attention to fluctuations in the US stock market, providing a re-allocation opportunity after the pullback. We previously mentioned in "How much room is left in the US stock market?" that in the short term, with the continued optimism, US stock valuations are at high levels, requiring attention to the "risks that have risen." The recent pullback confirms our view. Based on our calculations of the rate cut expectations, the magnitude of the US stock market is not exaggerated. However, from the perspective of equity risk premiums, current US stocks are still not "cheap," and it is necessary to pay attention to whether there will be disruptions in the short term. Currently, the S&P 500 index's ERP is only 0.02%, close to levels seen after Trump's election on November 6, and the lowest level since the tech bubble. Therefore, if some data falls short of expectations or if the policy progress and degree of optimism following Trump's election are not as expected, this could potentially trigger a partial "correction" in market sentiment. However, our outlook for the mid-term trajectory of the US stock market is not pessimistic, and there may be opportunities for re-allocation after further declines. Looking at the economic cycle, we expect the US economy to regain momentum in the middle of 2025, providing profit support for US stocks. If the debt ceiling issue is resolved quickly, short-term bond issuances in the first quarter could also further release the size of overnight reverse repurchase agreements, supporting the trajectory of US stocks in terms of financial liquidity. Looking at the long-term trend, as long as there is no reversal in the three major pillars like the technology trend, the trend of US stocks may not have been broken. Under benchmark conditions, we estimate that a 10% increase in profits corresponds to a level of 6,300-6,400 for the S&P 500 index. From a short-term trading perspective: 1) at key support levels, the S&P and NASDAQ are around 5,700 and 19,000, respectively, meaning that as long as they do not fall below due to factors like fund liquidation and unexpected events, they can consolidate at these levels. 2) In terms of time, pay attention to multiple catalysts in January, such as non-farm payrolls and inflation, policy progress after Trump's inauguration on January 20, the Fed's interest rate decision on January 29, and the start of the fourth-quarter earnings season in mid-January. If these are navigated smoothly, it will be a better time for re-allocation. Gold's risk compensation is relatively high, and there is a risk of overstretch in the short term. The current price of gold is $2,622 per ounce, higher than our calculated fair level of $2,400 per ounce based on real interest rates and the US dollar's fundamental model. However, after the Russia-Ukraine conflict in 2022, the actual movement of gold prices often deviates from the above fundamental model, and the deviation can be seen as additional compensation for geopolitical situations and local "anti-dollar" demand. Through analysis, we find that this additional compensation has increased by at least $100 since 2022. But even considering this risk compensation ($2,500 per ounce), the current price is still on the higher side, which is why gold prices have seen sharp declines under certain catalysts recently. Therefore, even from a hedging uncertainty perspective in the long term, there is still value in allocation, and we recommend paying attention to the short-term risks of overshooting brought by a breakout in the US dollar. The risk premium calculated in the current Chinese market is basically reasonable and is at a level similar to that during the third round of tariffs in 2019. The current risk premium ERP for the Hang Seng index in Hong Kong is 7.46%, which is close to the level in May 2024. From a policy and fundamental perspective, the policies introduced after September 2024 are also basically reasonable compared to the expectations at the time, not as extreme as in early October, so we believe the market can be supported at this level. From the perspective of tariff expectations, the current ERP is similar to that in May 2019, when the US further increased its tariffs.The list of $200 billion tariffs, ranging from 10% to 25%, has gradually become "desensitized" to the impact of tariffs on the Chinese market. Although there have been fluctuations, the overall position range has been more stable than in 2018, which is related to domestic policy adjustments and fundamental improvements. In this sense, if future tariffs are only at 10% and gradually increasing, the market impact may be similar to 2019, as market expectations are already priced in and the fundamental impact is manageable. Compared to that, the Shenzhen Composite Index's ERP is 6.43%, slightly lower than in May 2024 and closer to 2019 levels horizontally, but significantly lower than Hong Kong stocks vertically.This article is reposted from Zhongjin Insight, GMTEight Editor: Chen Wenfang.