Monetary Policy Path: Increasing Probability of a Rate Cut in September, Q3 as a Key Window

In June, the CPI further weakened, combined with Powell's dovish remarks, opening the door for a rate cut by the Federal Reserve. Market expectations for a rate cut in September have risen to 90%, making it a highly probable event. After nearly half a year of brewing and pendulum-like swings, it seems that the rate cut is finally about to become a reality.

However, will assets trade as expected or as historical experience suggests? For example, many people worry that the market often declines during rate cut cycles, directly citing historical experience without differentiating the underlying reasons. Furthermore, is the beginning of a rate cut the start or the end of the rate cut trade? Which assets will benefit more, and how will the Chinese market perform? It seems it's not as straightforward as it appears. The ECB's hawkish rate cut in June provides a different insight. This article aims to answer these questions.

In fact, it's not just the CPI that has weakened recently. Since July, various economic data released have shown signs of weakening. The inflation indicators watched by the Federal Reserve have declined for three consecutive months. Last week's June inflation data showed that the overall CPI (2.97% YoY vs. expected 3.1%) and core CPI (3.27% YoY vs. expected 3.4%) were both significantly lower than market expectations, and the structure of inflation has improved significantly. The previously high rent has notably declined month-on-month, and medical services and transportation services have also cooled significantly. Additionally, recent PMI and unemployment rate data have shown weak performance, boosting market expectations for a rate cut in September.

Various assets are gradually pricing in the rate cut expectations. The current CME rate futures imply a 96% probability of a rate cut in September. The yield on the 10-year U.S. Treasury has fallen from a high of nearly 4.5% in early July to the current 4.2%. The dollar has weakened from 106 in early July to the current 104. Gold has risen from about $2300/ounce in early July to break through $2400/ounce. While U.S. stocks showed a flat performance on the day the inflation data was released, they have generally recorded gains since July.

The key factor determining whether the Federal Reserve will cut rates remains the decline in inflation. We estimate that inflation has a chance to fall quickly in the third quarter. Inflation may weaken due to cooling commodity inflation and gradually declining service inflation. The overall CPI could drop to 2.83% in August, and core CPI might fall to 3.23% in November.

However, by the end of the year, factors such as the base effect, excessive rate cut expectations leading to inflationary rebound, or election-related inflationary policies could pose some tail risks for inflation (we estimate PCE could fall to around 2.5% in August and rise back to 2.8% by the end of the year due to tail risk effects).

Therefore, the third quarter is the main window period for the Federal Reserve to cut rates. However, contrary to current market expectations, we believe that the rate cut this year may be limited in terms of magnitude and frequency.

Firstly, we have repeatedly emphasized that the Federal Reserve does not need inflation to fall to 2% to cut rates but needs to see a trend towards 2%. Federal Reserve Chairman Powell also stated in his testimony before the U.S. House of Representatives on Wednesday that rate cuts do not need to wait for inflation to fall to 2%.

Secondly, reviewing past rate cuts by the Federal Reserve shows that they are not always in response to economic recessions but also include preemptive cuts to mitigate financial risks. Therefore, in a similar vein, given the resilient demand backdrop, the Federal Reserve only needs to wait for an appropriate inflation window for a modest rate cut to ease monetary policy restrictions and address the inverted yield curve issue, without the need for continuous significant rate cuts.

If this is the case of a modest preemptive rate cut, which is relatively uncommon, how should we position for this round of easing? This report reviews the macro environment and asset performance during previous rate cut cycles since the 1990s.

Due to the significantly different backgrounds for rate cuts and the fact that many rate cuts were in response to economic recessions involving continuous significant cuts, which are notably different from the current modest rate cuts under a soft landing scenario, historical asset performance cannot be simply averaged. The current situation is more comparable to 1995 and 2019.

In the second half of 2024, our baseline assumption is that the U.S. economy will moderately slow down. This means that, of the past rate cuts, 1995 and 2019 are more comparable to the current situation.

Macro Environment: In both 1995 and 2019, the economy slowed down before the rate cut but did not enter a recession, and smoothly achieved a soft landing after modest rate cuts. In both periods, the Federal Reserve conducted three 25bp rate cuts, totaling 75bp. During the rate cut period, the U.S. unemployment rate remained stable, and the PMI clearly stopped declining after the rate cut. Before the end of the rate hike cycle and the start of the rate cut cycle, the decline in U.S. Treasury yields drove a significant rebound in real estate sales. However, after the actual rate cut, U.S. Treasury yields began to rise again, and the recovery slope of real estate sales slowed down marginally. The U.S. CPI established an upward trend during the rate cut cycle.

Asset Performance: From the historical experiences of these two periods, gold and U.S. Treasuries performed better before the rate cut, with their gains possibly narrowing after the rate cut. After several rate cuts, as growth gradually improved under a soft landing scenario, the allocation opportunities for long-term U.S. Treasuries and gold diminished as demand improved, gradually shifting to U.S. stocks and copper driven by the numerator logic.

Sector and Industry Performance: Before the rate cut, interest rate-sensitive sectors such as technology and media relatively benefited. After the rate cut, with demand improvement, industries with earnings recovery on the numerator side, such as real estate, financial services, banking, and the auto sector (post-real estate cycle), relatively outperformed.