The Federal Reserve’s rate hike cycle has largely concluded. To date, the Fed has refrained from elevating interest rates for three successive meetings. Federal Reserve Chairman Colin Powell has unequivocally asserted that interest rates currently reside “at or near the pinnacle of this tightening cycle.”
Global markets are now transitioning into the trading phase influenced by expectations of a Fed rate cut. The Fed officials’ benchmark interest rate forecast dot chart manifests an anticipation of three rate reductions in 2024, totaling up to 75 basis points. Nonetheless, the market envisions a more assertive rate cut, speculating it could reach 150 basis points in 2024 and anticipates the Fed to implement rate reductions in March 2024.
Since November 2023, U.S. stocks have experienced a substantial surge, attaining record highs. The S&P 500 has risen by over 15%, and the Nasdaq has surged nearly 20% in a mere two months. Simultaneously, U.S. bond rates have rapidly declined, with 10-year U.S. bond rates receding from a mid-October peak of around 5% to approximately 3.9%. The dollar has also initiated a weakening trend, with the dollar index diminishing by about 5% over the same period.
Capital markets adhere to a significant principle—buy expectations, sell facts. Historical observations of Federal Reserve rate cut cycles indicate that, during the stage of fermenting expectations preceding an interest rate cut, both the stock and bond markets exhibit superior performance. However, following the actual implementation of rate cuts, market performance tends to wane. This phenomenon is attributed to the market anticipating the outcomes in advance and the subsequent economic slowdown and rise in unemployment mitigating the impact of interest rate cuts.
In the prevailing “golden age” of trading, certain assets are poised to excel. U.S. bond interest rates boast heightened certainty, U.S. stocks are likely to ascend, commodities may face pressure, a weaker dollar is expected to alleviate depreciation concerns for emerging market currencies, and A shares are anticipated to reap benefits on both ends.
The looming question arises—will the March rate cut prove futile?
Since 2023, a strategic interplay has unfolded between the market and the Fed. Market expectations of the Fed’s actions have been characterized by a sense of urgency, with the Fed intermittently pulling market expectations akin to manipulating a rope. However, since November 2023, the Fed’s conduct has consistently gravitated toward aligning with market expectations, eschewing the metaphorical act of “pulling the rope.” Analyzing previous Federal Reserve rate increase cycles reveals an average time interval of approximately 7 months between the final rate increase and the initial rate cut. A rate cut in March 2024 aligns with this historical operational pattern.
The rationale behind the Fed’s reluctance to procrastinate in cutting interest rates is conventional. Maintaining a perspective is paramount, as monetary policy requires a certain duration to manifest its efficacy. Implementing a loose policy demands six months to a year for its full impact. Delaying action until a clear economic downturn ensues forfeits the optimal opportunity.
The Fed has grappled with foresight-related challenges. When signs of elevated inflation surfaced in the United States in 2021, the Federal Reserve failed to timely raise interest rates, attributing inflation to mere transience. This lack of forward-looking policies garnered market criticism, subsequently leading to intensified tightening measures after 2022 to combat high inflation. Now, as inflation recedes, the Fed faces a pivotal test of its foresight. With inflation on a downward trajectory, a precautionary rate cut is deemed a prudent strategy to avert subjecting the economy to excessive interest rates.
U.S. CPI registered a 3.1% year-on-year increase in November, marking a 6-percentage-point reduction from its cycle high of 9.1%. The U.S. core CPI witnessed a 4% year-on-year rise in November, down 2.6 percentage points from its cycle high. Given this inflationary backdrop, the Fed finds reassurance. The latest forecast indicates PCE inflation is expected to be 2.8% in the fourth quarter of 2023, down 0.5 percentage points from September’s projection, with a further decline to 2.4% in the fourth quarter of 2024.
As inflation recedes, even without Fed intervention, real interest rates post-inflation rise, obviating the need for elevating nominal benchmark interest rates. The initial two Fed rate hikes primarily served to gauge various economic sectors’ reactions to interest rates, assessing their appropriateness. However, the tone of the December Fed meeting shifted notably, signaling a predisposition towards a rate cut. Powell, in a press conference, acknowledged discussions within the Fed about when to implement interest rate cuts.
The significant surge in U.S. bond interest rates in October 2023 underscores the vulnerability of the U.S. bond market to disruptions in an environment of elevated benchmark interest rates exceeding 5%. This scenario is evidently unfavorable to financial stability.
Another pivotal factor is the impending 2024 U.S. election. From the Democratic Party’s perspective, maintaining a stable and robust economy in 2024 is imperative for electoral success. Although the current state of the U.S. economy is satisfactory, uncertainties persist regarding its trajectory in 2024 under the influence of high-interest rates. The IMF projects U.S. economic growth to be around 1.5% in 2024, lower than that in 2023. Preemptive “rate cuts” by the Fed before the election would ostensibly favor the Democratic Party. To uphold its proclaimed independence and mitigate suspicions, the Fed is well-advised to execute interest rate cuts in the first half of 2024, assuming a posture of neutrality as the election approaches.
Future developments may coincide with rate cuts. In the minutes of the December Fed meeting, some participants advocated for a gradual reduction, followed by suspension when the reserve balance slightly exceeds the level consistent with adequate reserves. They further proposed that the FOMC commence discussions on specific measures and timely public disclosure before initiating a reduction.
A discernible cycle governs the Fed’s interest rate adjustments, signifying that once rate cuts commence, there will inevitably be substantial basis points of interest rate reductions. The market typically begins to fully reflect the effects of the entire rate cut cycle following the initial cut.
U.S. debt stands as the asset class most directly impacted by interest rate policy cuts and economic downturn pressures, providing the highest level of certainty throughout the interest rate cut cycle. The performance of U.S. stocks is more intricate, exhibiting positive momentum in the early stages of an interest rate cut. However, post-cut, their trajectory is contingent on economic performance, with recession-style downturns exerting a negative influence on U.S. stocks.
During the 2019-2020 rate cut cycle, spanning from the cessation of the rate hike to approximately the initiation of the first rate hike (October 2018 to July 2019), US bonds and US stocks ascended in unison. The 10-year US bond rates witnessed a precipitous decline of approximately 170 basis points from their zenith, while the Standard & Poor’s 500 index exhibited a substantial surge of about 29% throughout 2019. In the 2006-2008 interest rate cut cycle, from the conclusion of the interest rate hike to the commencement of the first interest rate hike (July 2006 to September 2007), the interest rate on 10-year US bonds descended by approximately 90 basis points. Concurrently, US stocks showcased commendable performance, registering a 25% increase and attaining a new pinnacle prior to the subprime mortgage crisis.
In contrast, the predictability of the dollar’s performance before and after the inaugural rate cut lacks the same robustness. For instance, the dollar index experienced a marginal appreciation in 2019, whereas it depreciated by about 8% between July 2006 and September 2007. Commodities, influenced significantly by the contraction in global demand, often lag behind other asset classes.
Since the Federal Reserve halted interest rate hikes in July 2023, U.S. bond interest rates have steadily declined, reaching record highs for U.S. stocks. Simultaneously, the dollar index has experienced a certain degree of depreciation, and commodities have weakened. These trends mirror the performance of major asset classes before and after the Federal Reserve’s inaugural interest rate cuts in the past.
Having missed the “golden trading” period, uncertainty in trading has subsequently heightened. Post-expectations realization, a portion of the funds allocated for anticipated trading typically exits. The future prospect of a soft landing for the U.S. economy remains an exceedingly uncertain event.
If there is an abrupt and pronounced downturn in the U.S. economy following a period of interest rate cuts by the Fed, it often triggers a subsequent rate cut exceeding expectations. This, in turn, initiates a second wave of descending interest rates on U.S. debt. However, U.S. stocks tend to plummet sharply due to the severe economic downturn, commodities face adversity, and the dollar undergoes a sharp depreciation.
The subprime mortgage crisis in 2008 triggered a severe recession in the United States. The Federal Reserve implemented a 400 basis points interest rate cut in 2008 and commenced a quantitative easing policy. This resulted in a sharp decline of approximately 240 basis points in the interest rate of 10-year U.S. bonds post-September 2007. During this period, U.S. stocks performed abysmally, with the Standard & Poor’s 500 plummeting by more than 50% from its peak—an unprecedented bear market for U.S. stocks since World War II. Crude oil prices plummeted from $147 to around $30, and the dollar index depreciated by about 12%.
In 2020, shortly after the Federal Reserve initiated interest rate cuts, it confronted the onslaught of the new crown epidemic. The U.S. economy plunged into recession once again. The Federal Reserve promptly lowered the benchmark interest rate to zero and reintroduced a quantitative easing policy. This led to a decline of about 150 basis points in the interest rate of 10-year U.S. debt in the first quarter of 2020. During this period, the Standard & Poor’s 500 experienced a sharp decline of about 30%, and the price of crude oil futures temporarily plunged to single digits. From April to December 2020, the dollar index depreciated by about 9%.
Funds are anticipated to gravitate towards A shares.
Although the trajectory of A shares predominantly hinges on the sustenance of economic fundamentals, the policies enacted by the external Federal Reserve wield a substantial indirect influence on A shares. At the onset of the previous two rounds of Fed interest rate cuts, A shares exhibited robust performance. At the commencement of the Fed’s interest rate cut in 2019, A shares witnessed a significant rebound, with the Shanghai-Shenzhen 300 Index recording a 36% upswing that year. Similarly, at the initiation of the Fed’s interest rate cut in 2006-2007, A shares embarked on a substantial bull market, with the Shanghai-Shenzhen 300 Index surging by more than 300% during that period.
What factors render A shares prone to market buoyancy at the inception of the Fed rate cut? Will history repeat itself this time?
Primarily, from the denominator perspective, the substantial decline in US bond interest rates induced by the Fed’s interest rate cut cycle will markedly alleviate the depreciation pressure on the RMB. Since November 2023, the offshore renminbi has appreciated by about 2.5% to around 7.15, as global markets have engaged in the anticipated trading of Fed interest rate cuts. If the depreciation pressure on the renminbi continues to considerably ease, the central bank will also possess more leeway for monetary easing to bolster the recovery of the domestic economy. Lower interest rates will contribute to enhancing A-share valuations. In the initial stage of the interest rate cut by the Federal Reserve in 2019, the central bank executed RRR reductions and interest rate cut operations successively in September and November 2019, fostering a more relaxed domestic liquidity environment.
Secondarily, from the molecular perspective, the impact of the Fed’s rate cut cycle on external demand is intricate. Typically, the Fed’s initial rate cuts are “precautionary,” signifying that when the U.S. economy exhibits early signs of deceleration, the Fed takes preemptive measures. During this phase, the demand in the United States does not sharply decline. If the emerging market economy can sustain a certain resilience after the enhancement in liquidity, China’s overall external demand will not dwindle significantly. This, in turn, augurs well for the improvement of the molecular end of A shares. The twists and turns in China’s economic recovery in 2023 have been influenced significantly by a pronounced slowdown in external demand, resulting in a notable decline in export growth.
Ding Anhua, chief economist of China Merchants Bank, anticipates that overseas macro policy shifts and inventory cycle recovery will boost cyclical industry demand. The superimposition of stabilized export prices is expected to maintain a small positive growth in global trade in goods, leading to a projected 2% growth in China’s exports (denominated in US dollars) in 2024.
Additionally, from a liquidity standpoint, the flow of foreign capital exerts a more substantial marginal impact on A shares. Generally, when the RMB continues to depreciate, foreign capital is inclined to exit, imposing pressure on A shares. Conversely, when the RMB tends to appreciate, the influx of foreign capital is significant, enhancing the certainty of the A-share market. Following the Fed’s interest rate cuts, the depreciation of the dollar becomes more certain, creating an environment where the renminbi is expected to enter the appreciation channel. Coupled with the inflow of foreign capital, the A-share market is more aptly poised for initiation.
If A shares undergo a market surge, which style is anticipated to dominate? Huafu Securities posits that after the Federal Reserve initiates interest rate cuts, growth and consumption styles take the lead. Following the Fed’s first interest rate cut in August 2019, the growth style assumed precedence, trailed
by consumption. The valuation of growth stocks demonstrated a closer correlation with overseas liquidity, while consumption constituted a relatively weighty sector for foreign investment. On one hand, the Federal Reserve’s interest rate cuts facilitated the reduction of risk-free interest rates, conducive to the valuation growth of the plate. On the other hand, the narrowing interest rate gap between China and the United States heightened the attractiveness of the A-share market to foreign investment.
Of course, the forging of iron requires inherent toughness. At the commencement of the Federal Reserve’s interest rate cut in 2019 and 2006-2007, A shares emerged from more favorable market conditions. External factors served as catalysts, but the fundamental impetus was the robust recovery of China’s economy. Although China’s economic recovery encountered some setbacks in 2023, policies are gradually taking effect, and the economy is poised to enter a more assured recovery trajectory in 2024.