In anticipation of the market, the Federal Reserve began a new cycle of interest rate cuts by an “unconventional” method of cutting interest rates by 50 bps, officially ending the austerity cycle since the beginning of 2022. The advantage of “unconventional” interest rate cuts is that they respond quickly to “potential but not yet apparent” growth pressure, but the downside is that it is easy to “realise” the market's concerns about recession. After all, “unconventional” interest rate cuts are generally extraordinary actions to deal with extraordinary times, such as the 2001 internet bubble, the 2007 financial crisis, and the 2020 pandemic. Fortunately, by emphasizing that there are no signs of recession, the path of interest rate cuts cannot be linearly extrapolated, natural interest rates are higher than historical levels, and the remote path on the bitmap is smoother than expected by the market, etc., he created an image of being “ahead of the market” and being able to do more at any time, but not being forced to do more because of recessionary pressure (“The Federal Reserve's “Unconventional” Interest Rate Cut Begins”).

The market also did not see a 50 bp cut in interest rates as a “last resort” after the recessionary pressure increased sharply. Asset performance showed a combination of “loose and sufficient but not poor growth”, which was reflected in risky assets, especially growth styles. Because of this, the next few economic data are particularly critical, and will directly determine the path of interest rate cuts for the remaining two sessions of the year, as well as the slope between recession trading (US debt, gold), easy trading (double share bonds, leading growth stocks), and repair trading (leading in the post-cycle, such as real estate and industrial metals) balances.

After cutting interest rates by 50 bps in September, the Federal Reserve's “bitmap” shows that there is room to cut interest rates by 50 bps during the year and 200 bp for the entire cycle until 2026. There is a clear discrepancy with the CME futures forecast to drop 75 bps during the year and 200 bps in September 2025. The latter is more aggressive. So how many times does the Federal Reserve need to cut interest rates, and how much is enough? Where is the end of interest rates? To answer this question is essentially to answer when will monetary policy break out of the “limit” range, and when will it begin to boost growth?

When will monetary policy leave the “limit” range? The residential side has entered a state of relaxation, and the degree of contraction on the corporate side and the overall economy has rapidly narrowed

How to measure whether monetary policy is “restrictive” (restrictive) is not a matter of scrambling to observe its absolute level, but rather a comparison of the economyROIThat is, it is compared with the level of interest that energy savings in various parts of the economy can withstand. The current round of interest rate cuts is likely to have an effect faster than expected and normal historical experience. Similar to the logic of why interest rates were raised for a long time before they had a curbing effect on inflation, it is likely that the return on investment of the economy has clearly risen (that is, the “neutral interest rate” mentioned by Powell is significantly higher than pre-pandemic levels). In the first quarter of this year, the reason why US private sector credit was able to expand unexpectedly before interest rates were cut was, on the one hand, because monetary policy was not far from the boundary of return on investment and could soon be reduced to an easing range; on the other hand, it was also because various financing costs were based on interest rate interest rates on 10-year US bonds, which declined early due to expectations of interest rate cuts, without having to wait for actual interest rate cuts.

From this perspective, after thorough preparation of recent interest rate cuts and a rapid decline in interest rates on US bonds, we have noticed that the “restrictions” on the consumer side of monetary policy have basically been lifted, and restrictions on the corporate side and the overall economy have also been rapidly narrowed. Specifically,

In the residential sector, expectations of interest rate cuts and concerns about the recession have led to a sharp drop in financing costs, which have already been relaxed. Housing mortgages account for 75% of the residential credit structure, so we use mortgage interest rates and rental returns as measures of financing costs and return on investment in the residential sector. Interest rates on 30-year mortgages are basically in line with interest rates on 10-year US bonds. Expectations of interest rate cuts have led to a rapid decline in interest rate interest rates on 30-year mortgages. They have now fallen to 6.1% (as of September 19), which is far below the rental return of around 6.8%. Meanwhile, bank residential loan standards have also been relaxed in the third quarter (the share of tightened-relaxed banks was -1.9%).

In the corporate sector, financing costs have declined and return on investment has rebounded. There are no restrictions on large enterprises, and the level of restrictions for small and medium-sized enterprises has also been narrowed from 330 bp to 250 bps. The corporate sector's financing channels include both indirect financing (commercial and industrial loans account for 14%) and direct financing (corporate bonds account for 40%). Large enterprises prefer to issue bonds, while small enterprises rely more on bank credit. In terms of financing costs, high-yield and investment-grade credit spreads fell from highs in the fourth quarter of 2023 to 3.24ppt and 1.25ppt, respectively, in the historical quantiles of 30% and 15%. Coupled with the sharp decline in the benchmark interest rate, direct financing costs fell rapidly. High-yield yields fell 260 bps (9.6% vs. 7%), and investment-grade bond yields fell 163 bps (6.6% vs. 5%). The tightening standards for industrial and commercial loans for indirect financing have also dropped sharply, and the cost of new financing for small and medium-sized enterprises has also dropped from 9% to 8.6%. In contrast, there has been an increase in return on investment. The S&P 500 ROIC has always been higher than the credit spread since the current round of interest rate hikes. Currently, it is still moderately upward, and the margin with the credit spread has widened further, reflecting that financing for large enterprises has not been suppressed. The ROIC in the non-financial enterprise sector recovered after a lapse of two quarters. It rebounded from 5.6% to 6.1% in the second quarter, and the difference in new financing costs with SMEs narrowed from 330 bp in the first quarter to 250 bps.

In the overall economy, the gap between real interest rates and natural interest rates narrowed to less than 70 bp. For the economy as a whole, the difference between real interest rate and natural interest rate (the level of real interest rate when inflation is balanced with the output gap) can be used as the degree to which monetary policy suppresses and promotes the economy. In terms of financing costs, since the April high, real interest rates have continued to fall back from 2.3% to 1.6% due to expectations of interest rate cuts and concerns about growth. Natural interest rates, which reflect return on investment, have also begun to rise. Natural interest rates are valued differently under different models. One relatively high-frequency and simple method of estimation is to use the long-term interest rate of the Federal Reserve's bitmap minus the PCE target value of 2%. This indicator has also begun to rise to 0.9% since the second quarter (long-term interest rates in March, June, and September were 2.7%, 2.8%, and 2.9%, respectively). The difference between the two narrowed from 117 bp in the first quarter to 70 bps, reflecting an easing in the degree of suppression on the overall economic level. If the levels measured by the New York Federal Reserve and the Richmond Federal Reserve are used, this gap may be even narrower.

Furthermore, financial conditions also fell to the most relaxed moment since interest rate hikes in 2022. Financial conditions that cover a wider range of financial conditions can also be used as supplementary indicators to aid judgment (“The threshold for the Federal Reserve to cut interest rates”), and consists of items such as long-term interest rates, short-term interest rates, credit spreads, US stocks, and the US dollar. Since US stocks fluctuate greatly in the short term, the impact on short-term changes in financial conditions is also more obvious. This is also the main reason why US stocks have continued to ease financial conditions since this year. As a high-frequency indicator, financial conditions are 2 to 3 months ahead of the economic accident index. The recent recovery in the economic accident index was the result of the relaxation of financial conditions in July; ahead of the inflation accident index by 1 month, the tightening of financial conditions in August was reflected in the recent weakening of the inflation accident index.

Where is the end of interest rate cuts and interest rates? The 3.5% interest rate on long-term bonds can already boost demand. Further decline can further activate the existing real estate market

The effects of current easing in the overall economy and macro subsectors discussed above are all based on comparing “new” financing costs with return on investment to determine whether marginal improvements have occurred. However, if financing costs fall further below the “stock” level, then the pressure on various departments to pay interest will improve markedly, thereby stimulating an improvement in demand. Let's assume here that other conditions remain the same, and we only rely on falling financing costs to reverse the level of interest rates on US bonds.

The residential sector: 3.2% can further stimulate stock demand. As analyzed above, the current 3.7% US bond interest rate has driven interest rates on 30-year mortgages back below the return on rent, stimulating an improvement in marginal demand, but it is more of an attraction for first-time homebuyers. Relying on return on investment and financing costs alone cannot fundamentally solve the shortage of existing homes. Previously, homeowners locked in lower interest rates were limited in their willingness to sell, resulting in low inventory levels and high housing prices, which in turn curtailed residents' ability to buy homes. If interest rates on new mortgages are lower than existing mortgages, then residents' demand for home purchases can be further stimulated.

By dismantling the existing mortgage structure, it was discovered that only 13% of mortgages have interest rates above 6%, so the current 6.1% financing cost is not entirely attractive, and it is impossible to effectively improve the current situation where supply and demand do not match. What's more, the overdraft in demand for home purchases after the pandemic caused residents to be unwilling to move, and only 25% of people are prone to replacement while keeping the original interest rate unchanged [1]. If mortgage interest rates fall back to 5%, the maximum share of potential listed homeowners can reach 22%, or supply can be increased to some extent. Interest rates on 30-year mortgages did not change one-to-one. The average interest rate spread between the two widened after the pandemic due to inversion of interest spreads and the Federal Reserve's downsizing of MBS. Assuming a return to the average level of 180 bp [2], it corresponds to a 10-year US bond interest rate of about 3.2%.

Corporate sector: The current level of interest rates can already improve the pressure on stocks to pay interest. The disclosure of stock interest rates on industrial and commercial loans for indirect financing is relatively lagging behind. The changes brought about by the fall in US bond interest rates in the third quarter and the Federal Reserve's interest rate cut have not yet been announced. Currently, the stock level in the second quarter remained flat at 6.7% in the first quarter, and ROIC increased to 6.1% from 5.6% in the first quarter, driving the gap between the two to narrowed from 1.1 ppt to 0.6 ppt. Since interest rates on industrial and commercial loans are highly correlated with interest rates on 10-year US Treasury bonds, we estimate that the current interest rate of 3.6 to 3.7% of US bonds basically corresponds to an effective interest rate of 5.3 to 5.5% for industrial and commercial loans. Under the premise that growth repair supports ROIC (6.1% in the second quarter), overall corporate stock financing costs may have fallen below the return on investment in the third quarter.

Overall economy: 3.5% to 3.6% can basically smooth out the difference between real interest rate and natural interest rate. As mentioned above, the calculation results of different models of natural interest rate are different. The LW model forecast value is 1.22%, the HLW model forecast value is 0.74%, the Richmond Federal Reserve's forecast value is 2.6%, and the Federal Reserve's 0.9%. The average value is about 1.4%. Currently, there is still a gap of 10 bp to 20 bp between the real interest rate and the natural interest rate. If this gap is bridged, assuming that inflation expectations remain unchanged, the real interest rate may drop to 1.4% to 1.5%, corresponding to the 10-year US Treasury interest rate of about 3.5% to 3.6%.

What are the implications for assets? Easy trading rather than recession trading, with denominator assets gradually shifting to molecular assets; short-term debt, real estate chains, and industrial metals can gradually be watched

Based on asset experience in the interest rate cut cycle since the 90s, general rules show that denominator assets performed well before interest rate cuts (such as US bonds, gold, Russell 2000, and small-cap growth stocks represented by Hong Kong stock biotechnology). After interest rate cuts, easing effects gradually became apparent, and molecular assets began to outperform (such as copper, US stocks, and cyclical sectors) (“Interest Rate Cut Trading Manual”). However, there are differences in each cycle, and differences in the macro environment will lead to differences in asset trends and trading logic. For example, in the 2019 interest rate cut cycle, after the first interest rate cut, interest rates on US bonds gradually bottomed out, gold gradually peaked, and copper and US stocks gradually bottomed out and rebounded, so a switch was achieved. Therefore, in a context where 2019 is more likely to be the benchmark situation, investors are advised to “think the opposite and do the opposite” at this stage.

Looking at it now, unconventional interest rate cuts starting at 50 bp will still cause the market to worry about whether future growth will face greater pressure in the short term. Therefore, several future economic data will be critical. They will determine the slope between recession trading (US debt, gold), easy trading (leading growth stocks), and repair trading (leading in the post-cycle, such as real estate and industrial metals) balance. If the data does not deteriorate drastically, and as we expected, there can be improvements on some interest-sensitive sides, such as real estate, etc., then it will deliver a combination of “interest rate cuts sufficient and the economy is not bad” to reach a new balance, and then move to the main line of the market or repair transactions after interest rate cuts.

Therefore, in the current environment, with the expectation that US bonds and gold cannot be falsified, there may still be some opportunities to hold, but the short-term space is limited. If subsequent data confirms that there is little economic pressure, then these assets should be withdrawn in due course; in contrast, what is more certain is that short-term debt directly benefiting from the Federal Reserve's interest rate cuts, the gradually repaired real estate chain (which even drives China-related export chains), and copper are gradually paying attention, but currently they are still somewhat on the left, and we need to wait for the next few data to verify the “New Ideas for Interest Rate Cut Transactions”).

This article is reprinted from CICC Dianjing, editor of Zhitong Finance: Chen Wenfang.