The Fed Will Cut Rates by 50 Basis Points This Year
The long-awaited interest rate cut finally materialized, marking the first such move in four years and an extraordinary cut of 50 basis points (bps). Following this announcement, U.S. stock markets experienced a notable rally, and the Asia-Pacific markets demonstrated a positive opening on September 19. However, the anticipated effect of the 50 bps cut had already been largely factored into the market earlier in the week, leading to an increase in U.S. Treasury yields rather than a decrease. Additionally, currency traders, particularly those dealing in non-U.S. currencies, engaged in profit-taking, which prevented the dollar index from suffering a significant decline.
Federal Reserve Chair Jerome Powell struck a hawkish tone to neutralize the potential market interpretation of the significant rate cut as a response to economic downturn. He emphasized that this move was merely a step towards normalizing interest rates rather than an emergency measure. Given that the current real interest rates (nominal rates minus inflation expectations) are above 3%, they have not been this high since the financial crisis. Powell reassured that the U.S. economy and labor market remain healthy and cautioned market participants against interpreting the 50-bps cut as the beginning of a series of future reductions. Interestingly, the median forecast from Federal Reserve members for interest rates at the end of 2024 stands at 4.4%, down by 0.7% compared to the June meeting, and they have lowered the forecast for 2025 from 4.1% to 3.4%. Nevertheless, these figures still fall short of the market's reduced expectation of nearly 225 bps in cuts.
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As of 10:30 AM Beijing time, the USD/CNH (offshore Chinese yuan) was trading at 7.0995, with the Shanghai Composite Index up by 0.82% and the Hang Seng Index up by 0.75%. Currency expert Liu Yang, who is the head of the financial markets division at Zhejiang Zhongtuo Group, commented, "The prior expectations for a rate cut were already quite pronounced, and the market had significantly built up positions along that trend. Once the 50 bps cut was realized, the forex market saw significant profit-taking. Given the high uncertainty surrounding the upcoming U.S. elections, it’s unlikely we’ll see a further decline in the dollar index. Currently, the USD/CNY exchange rate is largely influenced by external factors."
The realization of the interest rate cut acted as a catalyst for gains in the Asia-Pacific stock markets. Driven by considerations of inflation progression and risk balance, the Federal Reserve has lowered the federal funds rate target range to 4.75% to 5%.
Market observers were particularly focused on Powell's statements and the economic outlook projections (SEP) shared after the meeting, with keen interest in the "dot plot" that predicts future interest rate paths. In his post-meeting press conference, Powell remarked that while there has been progress on inflation and some slowing in labor market conditions, broader economic indicators still point to relative stability. He acknowledged significant shifts in the committee's stance compared to June, but reiterated that the current rate cut shouldn't be interpreted as a signal for future easing. The committee will continue to adjust its stance in response to forthcoming data, and Powell indicated that the Fed would maintain its balance sheet reduction strategy.
The latest economic forecasts and dot plot indicate a reduction in the expected GDP growth rate for this year to 2%, along with an increase in unemployment rate forecasts for 2024 and 2025 to 4.4% and 4.3%, respectively. Price indicators, particularly the PCE for 2024, have been adjusted down from 2.6% to 2.3%, with further downward revisions for the core PCE figures in subsequent years.
The latest dot plot shows the committee's median rate forecast for 2024 at 4.4%, a reduction of 0.7% from the June meeting, while the prediction for 2025 has shifted down from 4.1% to 3.4%, with the expected rate for the end of 2026 adjusted to 2.9%. This suggests that while there may still be two rate cuts of 25 bps each within this year, the total expected cuts over the long term are less aggressive than market predictions.
As a result of the rate cut, the Asia-Pacific stock markets surged, with Japan's Nikkei 225 index jumping nearly 3%, and both the Shanghai Composite and Hang Seng indices climbing close to 1%.
Financial institution UBS noted that historically, U.S. markets perform well during interest rate cuts that do not coincide with recessionary periods, and this trend is not expected to deviate much this time around. Their baseline scenario anticipates the S&P 500 could rise to 5,900 by the end of the year, and reach 6,200 by the end of June 2025. Concurrently, the Asia-Pacific stock markets tend to benefit from easing monetary policy.
Since August, the Hang Seng Index has rebounded over 5%. Zhao Wenli, Chief Analyst for Hong Kong stocks at Jianyin International, shared with reporters that the overall performance of the Hong Kong stock market has slightly exceeded expectations, particularly among companies in sectors such as internet platforms and technology hardware. Additionally, the onset of a rate-cutting cycle by the Federal Reserve has provided favorable liquidity conditions for gains in Hong Kong stocks. As growth companies continue to recover their earnings, market sentiment is expected to shift gradually.
On the other hand, Morgan Asset Management shared concerns with journalists, pointing out that while the commencement of a rate-cutting cycle by the Federal Reserve is generally beneficial for both equity and bond markets, persistent economic and geopolitical risks still introduce uncertainty. Discrepancies between market expectations and actual policies may also lead to fluctuations, prompting investors to mitigate concentrated risks and focus on enhancing the quality and diversification of their portfolios.
Amidst all this, the dollar's performance prior to the upcoming elections is expected to remain strong, while non-U.S. currencies have entered a stage of profit-taking. The forex market, having already priced in the rate cut expectations, is showing signs of "selling the facts."
Non-U.S. currencies are broadly re-adjusting to a rising dollar, for instance, USD/JPY rebounded to around 143 after dipping below 140 earlier in the week; USD/CNH briefly approached 7.08 before trading around 7.0945 on the 19th. As of July 19, at 11:15 AM, USD/CNY was at 7.092 and USD/CNH was at 7.0948.
Liu Yang observed that, "The pricing inclination in the forex market has been extreme. The pound, euro, and yen had all marked new highs against the dollar this year, but the Federal Reserve has taken a more moderate approach, leading to current profit-taking in the market." With the impending November U.S. elections, uncertainty is expected to increase significantly, making it unlikely for the dollar index to drop further.
Huang Jiacheng, Managing Director and Head of Fixed Income for the Asia-Pacific region at Invesco, remarked to reporters that there have been surprising election outcomes in South Africa, India, and Mexico, along with early elections in France, which have contributed to short-term market volatility. However, the forthcoming U.S. elections are likely to have the most consequential impact on the future, influencing trade policies, fiscal policies, and more. Furthermore, recent events in the Middle East underscore ongoing geopolitical risks; if the Democratic Party wins in the U.S., it may not favor conflict resolution, reiterating the geopolitical landscape's inherent challenges.
Despite the short-lived profit-taking among bullish sentiment towards the renminbi, analysts still believe there are grounds for the currency to appreciate. Certain traders indicated that if both internal and external factors align, it is not out of the question for it to touch or break the 7 threshold again.
Moreover, the "settlement effect" is receiving attention. Over the past two years, given the appreciation of the dollar and a significant interest rate differential between China and the U.S., many Chinese exporters have predominantly retained their foreign currency earnings in the form of dollar deposits instead of converting to renminbi. This behavior has contributed to pressing the renminbi down. Nonetheless, recent assessments from major investment banks suggest that exporters in China could convert a hefty sum of around $500 billion into renminbi assets, especially against the backdrop of anticipated Fed rate cuts, potentially leading to further appreciation of the renminbi against the dollar.
Liu Yang further noted, "A considerable amount of the export settlements has already emerged; however, the stock of dollars available for conversion this year may not be as abundant as it was in 2020. The actual amount of dollars available for sale could be around $200 billion. However, if key U.S. economic data remains disappointing, after a brief market pause, trading sentiment surrounding recession and rate cuts may push USD/CNY down to the 7 level."
Overall, mainstream perspectives suggest that for the renminbi to appreciate like it did in 2020, key conditions require continuous improvement in exports, sustained settlement by enterprises, and speculative positions consistently favoring a weaker dollar against the renminbi.