At the end of last year, when the Federal Reserve was just beginning to signal the end of its current interest rate hike cycle and the possibility of a rate cut in the future, the market aggressively bet that the Federal Reserve would cut interest rates 6-7 times this year, marking the first rate cut since March. After three months, accompanied by sustained strong US economic data, geopolitical conflicts have brought greater uncertainty to inflation. Federal Reserve officials are constantly raising their hawks, and market expectations for Fed rate cuts have been significantly lowered.
This week, the Federal Reserve will hold its latest Federal Open Market Committee (FOMC) meeting. What is the prospect of the Federal Reserve cutting interest rates within the year? How will the escalation of the Middle East situation and this year’s US election affect policy prospects? How will the quantitative tightening (QT) policy be adjusted in addition to interest rate cuts? The market has already priced multiple interest rate cuts before. If the rate cuts fall short of expectations, how will US stocks and bonds adjust? On these hot topics, a reporter from First Financial interviewed Cui Xiao, a senior American economist at Baida Wealth Management in Switzerland.
(‘Cui Xiao, Senior Economist at Swiss Baida Wealth Management in the United States (Interviewee provided)’,)
What are the risks of the Federal Reserve’s interest rate cut this year
First Financial:
Cui Xiao:
Meanwhile, we continue to anticipate that the threshold for the Federal Reserve to raise interest rates again this year will be very high.
First Financial:
Cui Xiao:
From a micro perspective, when observing inflation, the Federal Reserve simultaneously focuses on three aspects that affect the core consumer price index (CPI), namely housing inflation, core service industry inflation (excluding housing), and commodity inflation, as well as the broad consumer price index (CPI). Among them, we believe that inflation in the US housing market will continue to decrease as rental prices continue to decline. In terms of employment data, especially the growth of new employment is very strong, but this is partly due to the strong immigration momentum from last year and this year, which has strengthened the growth of monthly employment data. But because immigration has also expanded the labor supply, it has not actually put much pressure on wage growth. Therefore, we believe that wage increases will continue to decrease, which will help to reduce core service CPI and overall inflation.
Among the three core inflation factors, the most uncertain one is commodity inflation. Including the conflict between Palestine and Israel, as well as the previous situation in the Red Sea and Panama Canal, these will actually affect the supply chain, leading to an increase in prices of commodities such as crude oil. The gasoline prices in the United States are already on the rise and will be reflected in the CPI data for April and May. Therefore, the rise in oil prices and supply chain pressures will bring some upward risks to inflation due to the rise in prices of other commodities.
Nevertheless, for the Federal Reserve, if such geopolitical conflicts do not cause persistent increases in crude oil and agricultural prices, we believe that the Fed may overlook this short-term inflation risk.
First Financial:
Cui Xiao:
On the other hand, an increase in oil prices will affect consumer spending power, meaning that consumers may consume less oil. Therefore, although it may lead to an increase in inflation, the magnitude of the increase will be more limited as consumers reduce their consumption. Anyway, for the Federal Reserve, although the probability of their recent interest rate cuts is decreasing, they also feel that the current monetary policy is in a very tight state, so they will now balance both economic risks, that is, in addition to measuring inflation risk, they will also measure the risk that labor or US consumer spending power cannot maintain the previously strong level.
How the US General Election Affects Federal Reserve Policy
First Financial:
Cui Xiao:
For example, 2016 was the year of the US election, and the Federal Reserve raised interest rates for the first time in December 2015. At the beginning of 2016, the Federal Reserve also signaled to the market that they needed to continue raising interest rates, but in fact, the Federal Reserve waited until after the December 2016 election for a second rate hike. Dudley, then Chairman of the Federal Reserve of New York, said at the time that the Federal Reserve chose to do so because if interest rates were to be raised again at a Federal Reserve meeting close to the election, it would send a signal to the market that we feel it is very urgent to change policy now. However, the Federal Reserve believed that there was no need to convey this signal to the market, but rather hoped that the market felt that policy adjustments did not have any sense of urgency.
We now also believe that there is no sense of urgency in the Federal Reserve’s policy adjustment, as inflationary pressure still exists and is still above the Federal Reserve’s 2% target, and the labor market is still strong. Therefore, if the Federal Reserve adjusts its policy for the first time at its last FOMC meeting before the election, which is in September, there will be some political risks.
In addition, there is another reason why we expect this, which is
First Financial:
Cui Xiao:
But as mentioned earlier, although the US labor market is still strong, if we look at some more detailed data, such as people’s turnover rates returning to pre pandemic levels. The turnover rate is a reliable forward-looking factor for salary. Moreover, if the inflation rate continues to rise for 3-6 months, and economic data such as labor force is even stronger than currently available, it cannot be ruled out that the Federal Reserve will respond to these data by further raising interest rates to mitigate the risk of not landing.
First Financial:
Cui Xiao:
So, in fact, from the history of the Federal Reserve, it does face some challenges in how to gradually raise inflation from a very low level to the target level. But in terms of how to gradually reduce high inflation, such as in the 1970s and 1990s, the Federal Reserve was often able to achieve better risk control by raising interest rates. So, the Federal Reserve has relevant monetary policy tools to control the risk of non landing.
The impact on the market depends on the specific reasons for slowing down interest rate cuts
First Financial:
Cui Xiao:
If it is because of such a situation that the Federal Reserve reduces interest rate cuts, it is not necessarily a bad thing for the US capital market, especially for US stocks. Because this delay or reduction in interest rate cuts is due to the fact that the US economy is indeed growing well, it can provide a good economic fundamentals for the US stock market, and the US stock market should continue to improve, after all, the US stock market is not only affected by the prospect of interest rate cuts.
First Financial:
Cui Xiao:
An important point is that,
In addition to the impact of the balance sheet reduction policy on US bond liquidity and the US bond market, the US fiscal deficit, including how much new US government debt is issued, will also affect the US bond market. At present, we do not expect any policies to significantly increase the fiscal deficit before the US election, so the US fiscal deficit this year should be lower than last year, and the issuance of US bonds should also be lower than last year. Overall, these should be positive factors for the US bond market.
First Financial:
Cui Xiao:
For regional banks, their borrowing amounts for commercial real estate loans have decreased very quickly, not only from the demand side but also from the supply side. Regional banks are currently very adept at borrowing cards in this field. So, all aspects of this field are in a very tight state, and there will be no significant improvement in the short term.
However, the exposure of major US banks to commercial real estate is still very small, and their deposits are relatively stable, so there is not much concern in the commercial real estate sector. Most of the “thunderstorms” are regional banks, and if we look at their valuations, these regional banks are currently at a relatively low level, where investors have fully priced commercial real estate risks. Based on this, the impact of the commercial real estate sector on the overall banking industry in the United States is limited.
In addition, the proportion of commercial real estate in the US economy is also very small, so the commercial real estate industry will not have a significant impact on the fundamentals of the US economy, including Gross Domestic Product (GDP) and the job market.