At the November FOMC meeting that ended today, the Federal Reserve cut interest rates by 25bp to 4.5-4.75% as expected. Powell gave answers at the press conference regarding the recent employment and inflation situation, as well as the prospects of interest rate cuts in the US election, and even whether he will resign. Overall, the tone of this meeting is neutral, with an open attitude towards the future path. The market has responded positively, with US bond rates and the US dollar falling, and the Nasdaq and gold rebounding.
Since the unexpected significant interest rate cut of 50bp in September ("The Fed's Unconventional Interest Rate Cut Start"), the Federal Reserve has experienced one unexpected inflation (September CPI), two unexpected and low expected non farm payrolls (September and October), and Trump winning the election ("What Does Trump 2.0 Mean for the World?"). Market expectations have also experienced another "swing" from pessimism to optimism: from worrying about the United States falling into recession before the September interest rate cut, to actually not declining so quickly and still having a "soft landing", and then to even worrying about the Federal Reserve cutting interest rates too quickly and the possibility of accelerating the risk of secondary inflation after Trump's victory.
With US bond rates hitting a new high and Trump elected, the market is generally concerned about why US bond rates have fallen instead of rising after the Federal Reserve cut interest rates? How many more interest rate cuts does the Federal Reserve have? How will the US election affect the prospect of future interest rate cuts?
Q1. What adjustments have been made to the policies and statements of the Federal Reserve? Reduce interest rates by 25bp as scheduled, fine tune wording, and narrow the path of market interest rate cuts
The Federal Reserve has cut interest rates by 25bp, bringing the benchmark rate down to 4.5-4.75%, which is in line with market expectations. In the statement of the meeting, the Federal Reserve slightly revised its wording on employment and inflation, such as changing the job market from slowing down to generally easing ("slow" to "generally eased"), after all, the data in the past two months has been greatly disturbed by temporary factors such as hurricanes and strikes. It removed the phrase "further" indicating that inflation continues to decline, and deleted the wording that the committee has greater confidence in inflation returning to 2%, because inflation exceeded expectations in September, and the market is still concerned about the risk of inflation fluctuations brought by Trump's policies in the future. It is not difficult to see a slight change in the Federal Reserve's assessment, but overall there is no risk of a significant deviation from the target (Powell stated that "the job market is not the main source of inflation pressure").
For the future path of interest rate cuts, Powell emphasized that it will depend on the economic situation at each meeting (not on any preset course). This is also easy to understand, after all, the impact of the upcoming US election on growth and inflation still needs time to be evaluated. Powell stated that there will be one non farm payroll and two inflation events before the December FOMC, which can provide more policy guidance. At present, the implied interest rate cut path of CME futures has significantly narrowed to a total of three interest rate cuts, one in December this year, one in March next year, and one in June next year. The end point of the federal funds rate will reach 3.75-4% in June 2025.
Chart: The implied path of interest rate cuts in CME futures has significantly narrowed, with a total of 3 interest rate cuts remaining.
Source: CME, Research Department of CICC
Q2. Why did US bond rates rise instead of falling after interest rate cuts? Correcting pessimistic expectations, interest rate reflexivity and the 'Trump deal'
A seemingly strange phenomenon is that after the Federal Reserve cut interest rates, US bond rates did not decrease but instead rose, becoming the low point of US bond rates, rising from 3.6% to 4.4%, an increase of 81bp, with inflation expectations rising by 31bp and real interest rates rising by 50bp. This is consistent with our repeated reminder that interest rate cuts should be done in the opposite direction and considered in the opposite direction. When interest rate cuts are realized, it may be the same as the view that US bond interest rates have bottomed out and rebounded, which is consistent with the 2019 interest rate cut cycle ("Interest Rate Reduction Trading Manual").
There are three reasons for this: firstly, the correction of overly pessimistic recession expectations. We do not recognize the previously amplified recession concerns influenced by emotions ("Judgment Basis and Historical Experience of Recession"), especially after some data improved, the market's pessimistic expectations were corrected; The second is the "reflexivity" of interest rates falling too quickly. The unconventional interest rate cuts by the Federal Reserve can increase the probability of a "soft landing" because by guiding the decline of US bond rates and all other financing costs based on this, it can reignite some demand, which in turn promotes the improvement of long-term growth expectations and leads to a rebound in US bond rates. This reflexivity is also occurring when interest rates rise. The third is the boost of the 'Trump deal'. The rising popularity of Trump, especially after his victory, has further pushed up interest rates due to growth and inflation expectations (What Does Trump 2.0 Mean for the World?).
If the expectation of the third point is likely to be more of an emotional game without much concrete evidence, the first two are at least enough to support the US bond interest rate to rebound to a certain level at the bottom of the interest rate cut. In other words, the current level may be somewhat overdrawn, but the direction of recovery is generally clear. Our reasonable central range for calculation is around 3.8-4%, so the previous US bond interest rate of 3.6% is obviously too low. Currently, we are looking at whether 4.5% will effectively break through due to emotional and event factors, otherwise it will also provide trading opportunities.
Chart: The Fed's interest rate cut actually became the low point of the US bond rate, rising from 3.6% in September to 4.4%, an increase of 81bp
Source: Bloomberg, Research Department of CICC
Chart: Changes in the credit cycle between China and the United States will determine the trend of assets
Source: Research Department of China International Capital Corporation
Q3. Will the election affect the decisions of the Federal Reserve? Not in the short term, but inevitable in the long term. The risk of rising interest rates is greater than the risk of falling
There is no direct impact in the short term, but it will affect growth and inflation in the long term. Powell stated that there is no direct impact in the short term, but over time, post election policies will have an economic impact. This answer was also expected. We believe the underlying message is that the Fed's decision to cut interest rates is not a political decision and will not change due to the election results. However, in the long run, many of Trump's policy proposals are unlikely to have an impact on future growth and inflation prospects, which in turn will affect the Federal Reserve's decision to cut interest rates.
When asked if he would resign voluntarily if asked to do so, Powell said he would not, while also stating that Trump cannot voluntarily remove him from office under the law. Previously, Trump also stated that he did not seek early dismissal of Powell's position, but welcomed a more dovish monetary policy. One of Trump's policies is low interest rates, and he publicly criticized Powell's interest rate hikes multiple times during his previous term, which has raised concerns in the market about the independence of the Federal Reserve. But he also made it clear that 'although there have been disputes between the two, we will not seek to remove Powell from his position as Federal Reserve Chairman in advance'. Powell's second term as Federal Reserve Chairman will last until May 2026, and his 14 year term on the Federal Reserve Board will end in January 2028.
Under Trump's election, especially with the 'Republican victory', the risk of rising interest rates outweighs the risk of falling. In Trump's policy framework, whether it is the incremental stimulus of tax cuts and increased investment, the supply disruption of tariffs and immigration, or the weaker dollar policy that is unclear but has a greater impact, the disturbance to interest rates is biased upwards rather than downwards. The Tax Foundation predicts that tax reduction policies for residents and businesses may boost GDP growth by 2.4 ppt over the next 10 years [4], but the policy of imposing tariffs will suppress GDP growth by 1.7 ppt. Taking all factors into consideration, it may boost GDP growth by a total of 0.8 ppt. PIIE estimates that CPI may rise by 4-7 ppt in the next 1-2 years under a benchmark scenario of 1.9% due to the impact of tariffs. The recent continuous rise in US bond interest rates, especially the significant surge to 4.4% on election day, is a reflection of its policy impact.
Q4, how many more interest rate cuts are there? Around 3.5% is an appropriate level, as the market has shifted from being overly optimistic to being overly pessimistic
The market's expectations for future interest rate cuts are fluctuating from one extreme to another, influenced by recent economic data, especially post election expectations. Currently, there are only three expected rate cuts for CME interest rate futures, in December of this year, March of next year, and June, with the endpoint at 3.75-4%. Although we have always disagreed with the previous market optimism, believing that the initial 50 basis points of interest rate cuts would lead to a reduction of more than 200 basis points by next year, this current expectation may be too pessimistic. We have calculated that a rate cut of around 3.5% (corresponding to another 100 basis points reduction) is an appropriate level.
From a rhythm perspective, inflation and economic data may gradually rebound by mid-2025, leading to a gradual halt in interest rate cuts. We estimate that inflation will rise year-on-year in the fourth quarter of this year due to base issues, but with the push of declining rent, there is little pressure for inflation and core inflation to fall back to the first quarter of 2025. We have calculated that by mid-2025, the rental sub item with the highest CPI weight may once again turn upward. In addition, with the recovery of demand, the upward pressure on other sub items will also be greater. In 2025, CPI will be at a year-on-year level of over 2%, and around 2.5% in 3Q25. The upward risk of inflation outweighs the downward risk, which comes from earlier demand recovery, as well as current supply chain disruptions such as the Middle East situation, port strikes, potential trade frictions, and restrictions on immigration.
Chart: Under Trump's election, especially with the 'Republican victory', the risk of rising interest rates is greater than the risk of falling
Source: Research Department of China International Capital Corporation
In terms of magnitude, a rate cut of around 3.5% is a reasonable level. 1) Returning monetary policy to a neutral perspective: Referring to the Federal Reserve model and the average value of the natural interest rate calculated by the dot plot, the actual natural interest rate in the United States is around 1.4%. Considering that the short-term PCE may be around 2.1% to 2.3%, cutting interest rates 4-5 times by 25bp to 3.5% to 3.8% is a reasonable level. 2) Taylor Rule Perspective: Assuming that the Federal Reserve assigns equal weight to achieving inflation and employment targets in 2025, with long-term inflation and unemployment targets of 2% and 4.2%, respectively, and an estimated long-term federal funds rate of 2.9%. Based on our estimates of the year-end unemployment rate and inflation levels of 4.2% and 2.3% (core PCE year-on-year), the appropriate federal funds rate under the equal weighted Taylor rule is 3.1%, but the upward trend and risk of inflation at the end of the year may lead to a smaller rate cut.
Chart: CPI in 2025 will be at a year-on-year level of over 2%, while in 3Q25 it will be around 2.5%
Source: Haver, Research Department of CICC
Q5, when will we stop shrinking the table? The continuous tightening of financial liquidity may prompt the Federal Reserve to gradually withdraw from balance sheet tightening soon
The main basis for the pace of balance sheet reduction is whether the reserves are sufficient. There is a non-linear change in the adequacy of reserves (How does the Federal Reserve end its balance sheet tightening?), so it is important to closely track and prevent in advance. In a sense, in 2019, the Federal Reserve was forced to expand its balance sheet due to a "misjudgment" of the impact of balance sheet reduction and the required reserve size of the financial system, which led to a "money shortage" in the repo market. This lesson also provides sufficient reasons for the slowdown in the pace of reducing balance sheets in May this year. The survey conducted by the New York Federal Reserve in July this year showed that most banks expect quantitative tightening to end in April next year.
Stop shrinking or gradually enter the field of view. 1) The surplus of overnight reverse repo is not much: According to data from the Federal Reserve, the overnight reverse repo, which once reached over $2 trillion, is a symbol of abundant liquidity in the United States and also serves as a good hedge against the impact of the Fed's balance sheet tightening. But currently, the scale has dropped to less than 200 billion US dollars. 2) Reserve/bank assets approaching critical value: The reserve demand curve is non-linear, measured by the ratio of reserves to bank assets to determine adequacy. 12% to 13% is the critical point for excessive and moderate adequacy, while 8% to 10% is the warning line for transition to deficiency. At present, the value has dropped to 13.7%, and from the experience in 2019, it can be seen that the possibility of nonlinear changes in the future is increasing. 3) Tightening liquidity indicators: unsecured interest rates such as the federal funds rate and secured interest rates such as SOFR are important observation indicators in the interbank market. When the liquidity in the interbank market is tight, the interest rate at which the highest premium is used to break down reserves (the 99% percentile federal funds rate) will be very close to or even exceed the upper edge of the target range, and SOFR will also surge significantly. In 2019, during the "money shortage", these two interest rates broke through the upper edge of the 2.25% federal funds rate set by the Federal Reserve at 5.55% and 5.25%, respectively. In October of this year, SOFR once again broke through the upper edge, attracting widespread attention.
Chart: The appropriate federal funds rate under the equal weight Taylor rule is 3.1%, but the upward trend and risk of inflation at the end of last year may lead to a smaller rate cut.
Source: Haver, Federal Reserve, Bloomberg, Research Department of CICC
Chart: Overnight Reverse Repurchase Margin is running low
Source: Haver, Research Department of CICC
Chart: Reserve/Bank Assets Approaching Critical Value
Source: Wind, Haver, Research Department of CICC
Chart: During the "money shortage" in 2019, two interest rates broke through the upper edge of the Federal Funds Rate of 2.25% set by the Federal Reserve at 5.55% and 5.25%, respectively
Source: FRED, Research Department of CICC
It is precisely because of these changes that discussions on liquidity and balance sheet reduction have begun to increase in the market and the Federal Reserve. The Federal Reserve released a new observation tool in October - the Reserve Demand Elasticity Index (RDE). The lower the value of this index, the greater the interest rate change caused by changes in reserves, which means that reserves are more scarce. As of October data, this indicator is close to zero (usually in the negative to zero range), indicating that reserves are still abundant. Overall, there will not be a serious liquidity shock in the short term, but it is getting closer to the threshold of stopping balance sheet tightening, which also means a comprehensive loosening of monetary policy.
Chart: SOFR broke through the upper edge again in October this year
Source: FRED, Research Department of CICC
Q6. What impact does it have on assets? Short term election trading dominates, providing trading opportunities after a surge
As we analyzed in 'What Does Trump 2.0 Mean for the World?', a Trump victory, especially if it is a 'Republican victory', will provide inertia for related assets to rise, benefiting risk assets and US dollar assets. However, considering that the expected inclusion and policy implementation will take time, the surge also provides some trading opportunities to do the opposite, such as US bond interest rates. 1) Overall, there is room for further escalation and interpretation in Trump's deals, "allowing bullets to fly a little longer"; 2) For assets such as copper, oil, and export chains that have been underestimated or not yet reflected in Trump's expectations, if subsequent policies are implemented, the degree of compensation required will be greater; 3) After reaching a certain level, trading opportunities such as US Treasury bonds and the US dollar will be provided in reverse. The expectation for gold to be included is too high, and it is in the opposite direction of increasing risk, so there is a risk of overdraft, as was the case in the previous two elections in 2016 and 2020. We have been reminding that the beginning of interest rate cuts is also the end of the interest rate cut trading. Looking back, the beginning of the Federal Reserve's 50bp unconventional interest rate cut in September actually caused the bottom of interest rates, which seems to be a "divergence" trend consistent with our repeated emphasis on the idea of "thinking and doing the opposite" in the report.
In the medium term, the election will bring significant changes to the growth and inflation prospects within the United States, as well as China's response to external and domestic demand. However, the moderate restart of the US credit cycle and the end of China's credit cycle contraction remain the benchmark situation. At this time, US assets are still in good condition, while China's structure remains the main focus.
Chart: The reserve demand elasticity index constructed by the Federal Reserve is close to 0, indicating that reserves are still abundant
Source: New York Federal Reserve, Research Department of CICC
The probability of the US stock market is not bad, with technology and pro cyclical trends being the main focus. Short term overvaluation and policy variables can cause disturbances, but the long-term growth prospects are not bad. The driving force comes from technology trends and the natural restart of private credit cycles in the countercyclical sector, which is also the main allocation line. Therefore, a significant decline is also an opportunity for allocation.
US Treasury bonds are unlikely to be good, but there are trading opportunities. We have been suggesting that interest rate cuts may actually lead to the low point of long-term US bond rates, causing the interest rate curve to flatten out. This is indeed the reality. Looking ahead, the low point of interest rates has passed, but due to short-term overdrafts, trading opportunities will still be available.
The US dollar is relatively strong, but we are concerned about intervention policies. The natural recovery of the US economy and post election incremental policies will both have a supportive effect on the US dollar, with our calculated central range being 102-106. But more importantly, Trump and his key economic advisor Lighthizer have repeatedly proposed the idea of a competitive devaluation of the US dollar.
There is a bias towards more neutral bulk products. The demand for copper is more related to China, while oil is more influenced by geography and supply. From the perspective of the credit cycle between China and the United States, we believe that further bearish sentiment at the current level is not significant, but the upward momentum and timing are still unclear and need to wait for a catalyst.
Gold neutral. Gold has already exceeded the range of $2400-2600 per ounce that we can support based on our quantitative models of real interest rates and the US dollar index. However, the geopolitical situation, central bank purchases of gold, and local demand for "de dollarization" have brought additional risk premium compensation. Since we calculated the situation between Russia and Ukraine, the average is 100-200 US dollars. In the long term, it can still serve as a hedge against uncertainty, but in the short term, we recommend neutrality.
