CICC: How to expect rate cuts on various assets?

CICC released a research report stating that the unexpectedly hawkish rate cut by the FOMC in December led to significant volatility in various asset classes. Following the hawkish rate cut, rate cut trading temporarily became the dominant logic, causing US bond yields and the US dollar to break out to the upside, while US stocks and gold plummeted. However, with the approaching inauguration of Trump on January 20th, his policy impact is bound to "make a comeback", understanding the current expectations included in various assets, how much rate cut expectations, how much other policy expectations, is crucial as a reference for judging the follow-up policy impact. The main points of CICC are as follows: Rate cut expectations: Most assets include expectations that are more hawkish than the Federal Reserve, providing opportunities for "reverse trading" The December FOMC meeting marked the end of the rate cut path for 2024, but not the end of the entire rate cut cycle. Since the beginning of this year, rate cut expectations have swung from one extreme to another several times, and extrapolating the expectations at any extreme position linearly is contrary to what was expected at that time, and it may be the case once again. The Federal Reserve is not unable to cut rates further. The current pause is because: on the one hand, in this cycle of "soft landing" or even not landing at all, there is no need for too many rate cuts. Given the close relationship between financing costs and investment returns, too rapid rate cuts may actually be counterproductive. On the other hand, many of Trump's policies will indeed change future inflation and the inflation path, and time is needed to observe. Therefore, contrary to the pessimistic view that the market is worried about, the Federal Reserve's early deployment of excess reserves is not a bad thing, it can leave more maneuvering space, and now being "hawkish" means that it can "cut" in the future. This also provides assets with opportunities for "reverse trading" after over-correction. Most assets include rate cut expectations that are more hawkish than the Federal Reserve's dot plot, and even higher than the expectations of CME interest rate futures. Calculated based on a 25bp rate cut, the rate cut expectations for the next year for various assets are: US 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 bonds: Short-term bonds imply a rate cut of less than once; long-term bond yields have already exceeded the level calculated by the bank. The implied interest rate expectation for 1-year US bonds is 4.3%, significantly higher than the bank's calculated reasonable center point of 3.5% based on two methods (corresponding to another 50-75bp rate cut). 1) Monetary policy returning to neutrality: the average natural rate of New York Fed, San Francisco Fed, and Federal Reserve dot plot is 1.4%, the estimated PCE for 2025 is 2.1% to 2.5%, therefore the nominal neutral rate is 3.5% to 3.8%, and it is appropriate to cut rates again 2-3 times based on this. 2) Taylor rule: assuming the unemployment rate and inflation level by the end of 2025 are 4.3% and 2.5% respectively, the appropriate federal funds rate under equal-weighted Taylor rule is 3.2%, and upward risks in inflation may lead to a smaller actual rate cut by the Federal Reserve. The current 10-year US bond yield is 4.6%, with an interest rate expectation of 4.16% and a term premium of 0.4%. Based on calculations: 1) Interest rate expectation: it is the average of future short-term rates. Assuming the short-term rates in 2024, 2025, and 2026 are predicted values from the Federal Reserve dot plot, and the short-term rates for the next 7 years are around 3.5% (1.4% natural rate + around 2.1% long-term inflation center), the reasonable level for the 10-year US bond yield expectation is 3.6%; 2) Term premium: assuming the term premium turns positive after the balance sheet reduction, given in the range of 30-50bp. Combining the two, the central point for the 10-year US bond yield is 3.9-4.1%. Copper: Implied rate cut for the next year is less than once, lower than CME futures. By calculating the implied inflation expectation, the relationship between the US dollar and the price of copper, the copper price implies inflation expectations, and assuming the unchanged real interest rate, calculating the implied 10-year US bond yield level based on this. The current LME copper price ($8831 per ton) implies an inflation expectation of 2.36%, plus a real interest rate of 2.22%, the implied nominal interest rate for copper is 4.58%, slightly higher than the actual value, corresponding to a rate cut of 12.9bp in the next year. Gold: Implies a rate cut slightly higher than once in the next year, slightly higher than CME futures. By calculating the implied real interest rate, the relationship between the US dollar and gold, the gold price implies a real interest rate, and assuming the inflation expectation remains unchanged, the 10-year US bond yield level included is calculated. The current price of gold (~$2622 per ounce) implies a real interest rate of 2.06%, slightly lower than the current 2.22% real interest rate, corresponding to a rate cut of 34.3bp in the next year. US stocks: The rate cut expectation included is the highest among all assets, averaging around two times, close to the Federal Reserve dot plot. By calculating the implied US bond yield level based on the relationship between dividend yield, interest rate, and US stock valuation, US stocks imply a lower interest rate level than the current US bond yield, implying a rate cut of around 2 times. This is close to the guidance of the Federal Reserve dot plot, with the S&P 500, Dow Jones, and Nasdaq indices ranked by the magnitude of rate cuts. In conclusion, using the benchmark of the Federal Reserve being able to cut rates 2-3 more times, the expectation of only 1 cut in CME futures seems overly pessimistic. Based on this standard, the expectations included in US stocks are relatively reasonable; the expectations included in US bond yields are obviously too low and could provide short-term trading opportunities; the rate cut expectations included in copper are also too low, hence there is room for an increase; gold does not seem to have excessive rate cut expectations, but in addition to rate cut expectations, it also includes other risk premium, so it is not considered cheap. Policy expectations: debt ceiling for US bonds, policy risks for gold, tariffs for the stock market In addition to rate cut expectations, the debt ceiling and fiscal policies after Trump's inauguration for US bonds, policy and geopolitical risks for gold, and tariff paths for the stock market will also have different impacts. Specifically, The rise in long-term US bond yields mainly reflects supply factors and growth expectations, rather than concerns about rate hikes and inflation expectations. The US Treasury expects the issuance of US bonds in the first quarter of 2025 to reach a high of $823 billion, the highest since the third quarter of 2023, which may explain the rise in term premiums. This indicates that the recent rise in long-term US bond yields is due to supply factors and growth expectations, not concerns about rate hikes and inflation expectations.The rise is driven by supply factors rather than concerns about rate hikes, by growth expectations rather than inflation expectations, which also explains why US bond yields have risen since December, but the stock market has not reacted much.Looking ahead, the debt ceiling will affect the short-term trend of US Treasuries, but if resolved smoothly, it will provide trading opportunities. Currently, the spread in the 10-year US Treasury is about 50bp, approaching the peak level corresponding to last October's issuance from an absolute level, but the upward movement from the bottom (73bp) is still less than the increase after the resolution of the 2023 debt ceiling and the massive issuance by the Treasury. Looking ahead, the debt ceiling that goes into effect on January 1 is worth paying attention to. If it is prolonged, it could lead to supply pressure to compensate for the TGA's subsequent debt, along with expectations of fiscal spending by the new government, which could increase the possibility of a short-term increase in the term spread. But if the negotiations are resolved smoothly, this supply fluctuation will be smoothed over and not lead to a surge in supply. Considering that the Republican Party controls Congress until 2025, the bank tends to favor the latter. Therefore, the current US Treasury rate of 4.6% seems relatively high from the perspective of rate cuts and supply factors (we calculate a fair range of 3.9-4.1%), which will provide temporary trading opportunities. US stocks should be watched for short-term volatility, providing opportunities for reallocation after a pullback. From the above calculations that include rate cut expectations, the magnitude of the US stock market is not exaggerated. However, from the perspective of equity risk premium, the current US stock market is still not "cheap", so it is necessary to pay attention to whether there will be disturbances in the short term. If some data falls short of expectations or the policy progress and direction after Trump's election are not optimistic, it could trigger some "corrections" in the market sentiment. However, the medium-term outlook for US stocks is not pessimistic, and a drop could provide opportunities for reallocation. Based on the economic cycle, it is expected that the US economy will regain momentum in the middle of 2025, providing profit support for US stocks. If the debt ceiling issue is resolved quickly, the issuance of short-term debt in the first quarter could further release the overnight reverse repurchase scale, providing support for the trend of US stocks from a financial liquidity perspective. From a long-term trend perspective, as long as the three pillars of technology trends do not reverse, the trend of US stocks may not have been disrupted. Under the benchmark scenario, a 10% increase in earnings corresponds to a level of 6300-6400 points for the S&P 500 index. From a short-term trading perspective: 1) In terms of points, the key support levels for the S&P and Nasdaq are around 5700 and 19000, meaning that as long as they do not fall below these levels due to fund closures or other trading and unexpected factors, they could consolidate at these levels. 2) In terms of time, pay attention to multiple catalysts in January, such as non-farm payrolls and inflation in January, policy progress after Trump's inauguration on January 20, the Fed meeting on January 29, and the start of the fourth-quarter earnings season in mid-January. If these events proceed smoothly, it will be a better time for reallocation. Gold presents a higher risk premium, watching out for short-term oversold risks. The current price of gold is $2622 per ounce, higher than the bank's calculated fair level of $2400 per ounce based on real interest rates and the US dollar's fundamental model. However, after the conflict between Russia and Ukraine in 2022, the actual trend of gold often deviated from the above fundamental model, with deviations being seen as additional compensation for geopolitical tensions and local "anti-dollar" demand. Through analysis, it is found that this additional compensation has increased by at least $100 since 2022. However, even considering this risk compensation ($2500 per ounce), the current price is still relatively high. Therefore, there may still be value in allocating gold long term despite hedging uncertainties, and it is recommended to watch out for short-term oversold risks brought about by a breakout in the US dollar. The risk premium currently included in the Chinese market is basically reasonable and comparable to the level during the third round of tariffs in 2019. The current risk premium ERP included in the Hang Seng Index is 7.46%, which is close to the level in May 2024. From a policy and fundamental perspective, the policies implemented after September 24 are basically reasonable compared to the expectations at that time, not as extreme as in early October, so the market is supported at this level. From the tariff expectations perspective, the current ERP is similar to May 2019 when the US further raised tariffs on a $200 billion list from 10% to 25%. However, the Chinese market has become more immune to tariff impacts, experiencing fluctuations but overall consolidating within a range, which performs significantly better than in 2018, which is due to domestic policy hedging and fundamental repairs at the time. In this sense, if the subsequent tariffs only increase by 10% and gradually escalate, the impact on the market may be similar to that of 2019. This is because the market expectations are more informed, and the fundamental impacts are also controllable. In comparison, the ERP of the Shanghai Composite Index is 6.43%, slightly lower than the level in May 2024, and similar to that in May 2019, but significantly lower than the Hang Seng Index.