Fed's First Cut in 4 Years: Preparing Stock, Bond, Forex Markets
The Federal Reserve is set to announce its interest rate decision for September, and it appears almost certain that it will restart the rate-cutting cycle after four years.
However, whether it will be a more prudent 25 basis point cut or a more aggressive 50 basis point cut is still a matter of significant debate in the market.
Nick Timiraos, a journalist known as the "Fed's megaphone," recently wrote that the Fed is in a "rate-cutting dilemma," with the balance between "fighting inflation" and "stabilizing employment" leaving the suspense of the cut's magnitude until the last moment.
As of now, the CME's "FedWatch Tool" shows that traders in the interest rate futures market estimate a 64% probability of a 50 basis point cut by the Fed, while the probability of a 25 basis point cut has dropped to 36%.
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Whether "stabilizing employment" will become a priority for the Fed's policy was initially widely believed that the Fed would cut rates by 25 basis points in September, a more cautious approach.
However, after Timiraos repeatedly stated that "the magnitude of the first rate cut is still uncertain" and "there is no fundamental difference between a 25 or 50 basis point cut," the market's bet on a 50 basis point rate cut by the Fed has been reignited.
The main starting point for supporting a 50 basis point rate cut by the Fed is centered on concerns about the labor market.
Bill Dudley, former chairman of the New York Fed, recently stated at the annual Future of Finance Forum in Singapore that there are strong reasons for the Fed to cut rates by 50 basis points in September.
Dudley believes that the US labor market has shown signs of slowing down, and the risks facing the US employment market are higher than the challenges of inflation, giving the Fed a reason to cut rates by 50 basis points.
In the context of the US economic recession risk not being fully lifted, Michael Feroli, Chief US Economist at JPMorgan Chase, believes that a 50 basis point rate cut in September is what the Fed should do.
Nomura Securities said in its latest report that Jack Hammond, head of US Treasury sales, said in a recent report that the future trend of the actual unemployment rate in the United States may be higher than the Fed's forecast, while core PCE inflation may be lower than the forecast.
The Fed has made several large interest rate hikes of 75 basis points during the rate hike cycle, so starting the rate cut cycle with a 50 basis point cut will not surprise the market, nor will it necessarily trigger market panic.
However, apart from JPMorgan Chase and Nomura Securities, most Wall Street investment banks believe that the Fed's rate cut in September will still be 25 basis points.
A moderate rate cut for the first time can give the Fed more time to judge and observe the impact of the policy shift on the economy.
Yang Ao, Chief Chinese Market Analyst at FXTM, analyzed to Xinhua Finance that the Fed is still expected to be a moderate rate cut of 25 basis points in September.
Yang Ao said that on the one hand, US inflation has not yet reached the Fed's policy target, and the core CPI is still rising month-on-month; on the other hand, the economic fundamentals do not yet support the market's recession expectations, and the rise in unemployment has only lasted for a few months, and the cooling trend in the job market is not very obvious.
Jim Reid, head of global economic and thematic research at Deutsche Bank, believes that the Fed usually manages the market's rate cut expectations through the media during the quiet period.
If the Fed is not satisfied with the current market expectation of a 50 basis point rate cut, it will clarify through the media before September 18 (Wednesday).
If there is no media "wind" before Wednesday stating that the rate cut is 25 basis points, then the market's expectation of a 50 basis point rate cut may further rise.
How will the Fed's subsequent interest rate path be?
The market's expectation of the Fed cutting rates by 50 basis points in September and continuing to cut rates has been reflected in bond prices.
The yield on the more interest rate-sensitive two-year US Treasury bonds has recently fallen sharply under the expectation of rate cuts, also ending the long-term "inversion" trend of the US Treasury yield curve that started in August 2022.
Randall S. Kroszner, the Norman Bobins Professor of Economics at the University of Chicago Booth School of Business and former Fed governor, said to Xinhua Finance that the market is continuously increasing its expectations for the Fed to cut rates by 50 basis points this week, so it is reasonable to expect the Fed to cut rates by 100 basis points this year.
The market generally expects the Fed to cut rates by 100-125 basis points before the end of the year.
Kroszner believes that for the subsequent Fed interest rate path, the market should pay more attention to the Fed Chairman Powell's remarks at the press conference after the decision.
If Powell emphasizes that the labor market is weakening and he is confident that inflation is moving towards the 2% target, then further rate cuts will definitely come.
Chen Jianheng, a fixed income analyst at CICC, said in a recent research report that the previous high interest rate, high oil price, and high salary "three highs" environment has reduced the support capacity of enterprises, residents, and finance for US domestic demand.
Although the Fed may adopt a conservative small rate cut operation in September, if the economy declines, the Fed may have to be forced to speed up, and the subsequent rate cut process may be accelerated.
Chen Jianheng believes that for the policy path judgment in the fourth quarter and next year, he is more inclined to believe that the Fed may currently underestimate the risk of economic spiraling down.
If the rate cut speed is slow in the early stage, triggering the self-realization of weak expectations, the Fed may have to increase the rate cut intensity again in the later stage.
The rate cut process is accelerated based on the path of a 25bp rate cut in September, and in the remaining November and December interest rate meetings in the year, if the economy falls back more than expected, the Fed may passively adopt a combination of 50bp+50bp.
Therefore, Chen Jianheng believes that US Treasury rates still have room to fall, especially the short-term rates that are more closely related to the policy rate, and the decline may be greater.
Dirk Willer, Global Head of Asset Allocation Strategy at Citibank, said that the US Treasury index shows that the median return rate of US Treasury bonds in the next 12 months after the Fed's first rate cut can reach 6.9%, but only 2.3% in the case of a "soft landing" of the economy.
How will the foreign exchange market react?
Kroszner analyzed to Xinhua Finance that the greater the deviation of the Fed's rate cut from the market's rate cut expectation, the greater the market's reaction.
If the rate cut is 50 basis points and accompanied by a "dove" forward-looking guidance, it is likely to put pressure on the US dollar trend and boost the exchange rates of non-US currencies such as the renminbi.
Kroszner said that if the market believes that the Fed pays more attention to the risk of substantial weakening of the US economy, this may increase global concerns about economic risks and push down the risk asset markets including China.
"Usually the Fed is the first to take action, but this time the European Central Bank has cut rates twice, and the Bank of England has also cut rates once.
The Fed's rate cut will make other central banks more willing to further accelerate the pace of rate cuts."
Kroszner believes that for the People's Bank of China, it may pay attention to the impact of the Fed's rate cut on foreign exchange, and the renminbi against the US dollar may strengthen.
Kroszner believes that the yen has been strong recently, and if the Fed cuts rates by 50 basis points and provides more forward-looking guidance on the interest rate path, the yen may strengthen further.
Japan is facing the highest inflation level in decades, so the Bank of Japan may continue to maintain a "hawkish" stance.
According to Goldman Sachs' analysis, when the US and several non-US central banks cut rates at the same time, the US dollar tends to perform better than other currencies.
However, when the Fed cuts rates with relatively fewer non-US banks, the US dollar tends to perform weaker.
At present, major central banks such as the European Central Bank, the Bank of England, and the Swiss National Bank have all started the rate cut cycle, and the US dollar index has shown a continuous downward trend.
How will the US stock market react?
David Kostin, a strategist at Goldman Sachs Group, said in a report released last week that although some investors believe that the speed of the Fed's rate cuts will be a key factor in the US stock market investment returns in the next few months, the US economic outlook is actually the most important driver of the US stock market.
Kostin said that if the market reflects that the Fed's loose policy is less affected by the economy, then despite the rise in bond yields, the US stock market will still rise.
On the contrary, if the market believes that the Fed will further loosen policy due to the deterioration of economic data, then even if bond yields fall, the US stock market will be in trouble.
Mike Wilson, Chief US Stock Strategist at Morgan Stanley, believes in a report that if employment data continues to show a weakening trend, regardless of whether the Fed's first rate cut is 25 basis points or 50 basis points, the market may trade with a risk-averse tone.
Morgan Stanley analysts said that the most similar background to the current US rate cut cycle may be the rate cut cycle in 1995, but the first rate cut was 25 basis points.
It is also the only rate cut cycle that is recognized as having achieved a "soft landing."
Looking at the trend of the US stock market during the "soft landing" period of the US economy in 1995, Yang Qinqin, an analyst at Huaxin Securities, said that during the "soft landing" rate cut period, stocks will experience a double hit of Davis, with the economy improving supporting EPS, and rate cuts helping to boost PE.
Looking at the performance of the US stock market industry, "soft landing" rate cuts are more beneficial to growth sectors such as healthcare and information and telecommunications.
According to statistics from the Huatai Securities research team, during the second half of 1995, the best-performing sectors were bio-pharmaceuticals, health equipment and services, and diversified finance; during the third quarter of 2019, the best-performing sectors were technology equipment, semiconductor equipment, and bio-pharmaceuticals.
Historically, what will be the reaction of the US stock market if the Fed cuts rates by 50 basis points?
Nomura Securities said in a report that by studying the trend of the US stock market after previous rate cuts of 50 basis points, it can be seen that one month after the Fed cut rates by 50 basis points, the S&P 500 index did not fluctuate much, small-cap stocks rose by 2.4%, technology stocks performed poorly, falling by 0.9%, and energy stocks performed better than technology stocks.After the Federal Reserve cut interest rates by 50 basis points, the small-cap Russell 2000 index rose significantly by 5.6%, while the S&P 500 index edged down by 0.5%.
Value stocks outperformed growth stocks, and technology stocks declined by 2.6%.