To The Moon

The current state of the United States economy is at the center of the market's disagreement over the "rate-cutting cycle".Some participants believe that the U.S. is on the verge of a recession, while others emphasize the resilience of the economy and continued growth.

Rate cuts and recession?

Current market expectations for rate cuts stem from two main directions:

1. If the U.S. economy falls into recession, the Fed may be forced to cut rates quickly (the first 50 basis points to start) to ease economic downward pressure;

2. If the economy continues to be resilient, the Fed may also take precautionary rate cuts (starting at 25 basis points for the first time) to ensure that the economy achieves a soft landing.

More than 70 common U.S. economic data indicators are divided into core, auxiliary and forward-looking indicators, and six areas of consumption, investment, real estate, credit, employment and other areas are analyzed in a comprehensive manner.The results show that:

1. Consumption core indicators are healthy and forward-looking indicators have not weakened significantly

2. Investment data core indicators are healthy, but forward-looking indicators cool down

3. Real estate core indicators diverge, forward-looking indicators cool down

4. Credit and employment core indicators have cooled down significantly

Summary: Consumption>Investment>Property>Employment>Credit, showing a trend from strength to weakness.The high interest rate environment has shown cooling in the credit and job markets.

For the time being, a 25 basis point rate cut is still the benchmark expectation, mainly because there are no signs of a deep recession.Historically, the first rate cuts of up to 50 basis points have tended to occur during financial crises and have caused U.S. stocks to plummet in the future.

• While a 25 basis point rate cut may not completely remove recessionary fears from the market, the risk of a 50 basis point rate cut is that it could trigger a larger economic panic;

• At the same time, although the Federal Reserve has not yet begun to officially cut interest rates, the market has begun to feel the effects of easing;

• This is evidenced by the fact that as the 10-year U.S. bond rate has declined, the 30-year mortgage rate has fallen to 6.4%, which is below the average rental return of 7%.

  

• In addition, refinancing demand has recovered as mortgage rates have fallen.On the direct financing side, credit spreads on high-yield and investment-grade debt are at historically low levels, and declining financing costs have contributed to a significant increase in credit bond issuance, which rose 20.6% year-on-year in the U.S. between May and August.

The path of rate cuts

According to market expectations, the possibility of a rate cut in September has become a consensus, and the focus of the market has shifted from "whether the rate cut will happen" to "how much the rate cut will be".

Both scenarios signal the likelihood of future rate cuts, and the market has widely expected rate cuts to be earlier and deeper, rather than "shallow" or "slow".

From the CME's interest rate futures pricing

1. The probability of a 25 basis point rate cut in September is 73%, which is higher than the 27% probability of a direct rate cut of 50 basis points;

2. the probability of a direct rate cut of 50 basis points in November is 52.3%, the probability of a total rate cut of 100 basis points through the end of the year in December is 40.7%, and the probability of a rate cut of 125 basis points is 37.3%.

3. The probability of a rate cut of 175 basis points by March next year is the highest at 35.7%, and the probability of a rate cut of 225 basis points by June next year is the highest at 31.6%.

That is, market traders currently believe that the Fed will open the rate cut with a moderate 25 basis points, but the meeting faster pace, will be to the level of 3%.

Mainly still, recent data show that the U.S. core CPI and nominal CPI are showing a slowing trend, weakening supply chain pressures and cooling labor market further depressed inflationary pressures on core goods and services.

Assets performance expectations

The performance of assets such as gold and U.S. bonds has benefited from expectations of rate cuts, showing that investors are ready for deeper and earlier rate cuts.

Currently, different assets in the market are reacting differently to expectations of a rate cut.

• Interest rate futures have factored in 225 basis points of rate cut expectations

• Gold has factored in 83 bps

• Copper is 77 basis points

• U.S. bonds at 75 basis points

• U.S. stocks are at 29 basis points.

This means that, absent new recessionary pressures, the market has more than adequately factored in the expectation of a rate cut.As expectations of rate cuts materialize, markets will gradually shift from safe assets such as gold and United States bonds to risky assets such as equities and industrial metals.It also confirms the history of several previous instances where equity markets performed better after the first 25 basis point rate cut.

The 2019 rate cut cycle is a similar scenario

Prior to the Federal Reserve's first rate cut in July 2019, the 10-year U.S. bond rate had fallen from a high of 3.2% to 1.5%.Although risk assets experienced multiple pullbacks during this period, gold gradually topped out and U.S. stocks and copper prices began to rally as economic expectations improved and long bond rates bottomed.Similarly, in the current cycle, the market expects a similar change in asset rotation as rate cuts materialize.

Moreover, from a risk perspective, a different pace of rate cuts could lead to additional problems.

1. If rates were cut too quickly, it could lead to a re-acceleration of inflation;

2. A 50 basis point rate cut could signal concerns about the economy and trigger sharp market turmoil;

3. With a large rate cut, the stock market faces the risk of further unwinding of yen carry trades

Trading Strategy Analysis

If the Fed appears to cut rates aggressively?

Historical data suggests that a recession following an aggressive Fed rate hike is almost inevitable, so the logic of recession trading remains valid.For market participants, trading rate cuts offers a variety of possible strategies.

• First, U.S. bonds and gold are the most popular asset classes for trading rate cuts. $US10Y(US10Y.BOND)$ $US30Y(US30Y.BOND)$ $SPDR Gold Shares(GLD)$ $iShares 20+ Year Treasury Bond ETF(TLT)$

  • In the context of interest rate cuts, the decline in U.S. bond yields will drive bond prices up, and the attractiveness of gold as a safe-haven asset will also rise.

  • With the strengthening of the expectation of interest rate cuts, the U.S. bond interest rate curve gradually lower, the investor demand for long-term U.S. bonds increased significantly.And gold has also become investors' first choice for hedging, driven by election trading and global economic uncertainty.

• Second, stock market investors need to be cautious about market volatility in the context of aggressive rate cuts.Historical data show that the stock market tends to perform weakly in the early stage of a recession, and it is difficult to fully hedge against the risk of stock market declines in anticipation of interest rate cuts.Therefore, for investment in risky assets, it is recommended to adopt a neutral and cautious strategy and wait for further clarity on the Fed's policy before making a layout.

• The performance of commodities is closely related to the global economic cycle, especially copper and oil prices, which are usually affected by both the economic cycle and the expectation of interest rate cuts.Commodity prices have shown volatility in interest rate cut trading due to heightened market concerns about slowing global economic growth.Copper, in particular, as an industrial metal, has a strong link between its price and policy rates, and a rate cut could have a positive impact on its price in the short term, but the longer-term outlook remains dependent on a recovery in global economic demand.

If a mild rate cut of 25 basis points?then safe-haven demand will not lift all at once and the stock market may perform stronger.Different sectors are likely to perform better in a rate cut cycle there:

• Consumer stocks: consumers have easier access to credit in a low interest rate environment, so demand for consumer staples rises. $Consumer Discretionary Select Sector SPDR Fund(XLY)$

• Technology sector: low interest rates have reduced the cost of capital, allowing technology companies to invest more in R&D and expansion. $Technology Select Sector SPDR Fund(XLK)$

• Real estate: lower interest rates have reduced the cost of mortgages, increasing demand for real estate. $Real Estate Select Sector SPDR Fund(XLRE)$

• Financial sector: increased bank lending activity boosts earnings. $Financial Select Sector SPDR Fund(XLF)$

• Utilities: low interest rates reduce debt burden, boost infrastructure investment and financial stability. $Utilities Select Sector SPDR Fund(XLU)$

Summary

Overall, rate cut expectations have dominated the market and are trading with a high degree of certainty, regardless of whether the U.S. economy is in recession or not.The upcoming rate cut cycle is a very important trading cycle for investors to adjust their portfolios according to the characteristics of different asset classes.

Safe-haven assets such as U.S. bonds and gold will be important choices in the rate cut trade, while the stock market and commodities will need to be dynamically adjusted in conjunction with economic data and global economic conditions.

In the current market environment of high uncertainty, interest rate cut trading provides investors with a good opportunity to deal with future market volatility.