Title: Risks and Opportunities in the Early Stage of Interest Rate Cuts

Author: Web3Mario

Abstract: On August 23, 2024, Federal Reserve Chairman Powell officially announced at the Jackson Hole Global Central Bank Annual Meeting that "it is time for policy adjustment. The direction forward is clear, and the timing and pace of interest rate cuts will depend on the upcoming data, evolving outlook, and risk balance." This also means that the nearly 3-year period of Fed tightening has come to a turning point. If macro data does not surprise, the first interest rate cut is expected to occur at the September 19 meeting. However, entering the early stage of interest rate cuts does not necessarily mean an immediate surge, and there are still some risks worth being cautious about. Therefore, the author summarizes some of the most important issues to focus on at present, hoping to help everyone avoid some risks. In general, in the early stage of interest rate cuts, we still need to pay attention to six core issues, including the risk of a U.S. recession, the pace of interest rate cuts, the Fed's Quantitative Tightening (QT) plan, the risk of reigniting inflation, the efficiency of global central bank coordination, and U.S. political risks.

Interest rate cuts do not necessarily mean an immediate rise in risk markets; on the contrary, in most cases, they lead to a decline.

The Fed's monetary policy adjustments have far-reaching effects on the global financial markets. Especially in the early stage of interest rate cuts, although interest rate cuts are usually seen as measures to stimulate economic growth, they also come with a series of potential risks. This means that interest rate cuts do not necessarily mean an immediate rise in risk markets; on the contrary, in most cases, they lead to a decline. The reasons for this situation can usually be classified as follows:

1. Increased Financial Market Volatility

Interest rate cuts are usually seen as a signal to support the economy and the market. However, in the early stage of interest rate cuts, the market may experience increased uncertainty and volatility. Investors often interpret the Fed's actions differently, with some believing that interest rate cuts reflect concerns about economic slowdown. This uncertainty can lead to significant fluctuations in the stock and bond markets. For example, during the 2001 and 2007-2008 financial crises, despite the Fed starting an interest rate cut cycle, the stock market still experienced significant declines. This is because investors were concerned that the severity of the economic slowdown outweighed the positive impact of interest rate cuts.

2. Inflation Risk

Interest rate cuts mean a decrease in borrowing costs, encouraging consumption and investment. However, if interest rate cuts are excessive or prolonged, they may lead to increased inflationary pressures. When abundant liquidity in the economy chases limited goods and services, price levels may rise rapidly, especially in situations where supply chains are constrained or the economy is close to full employment. Historically, such as in the late 1970s, Fed interest rate cuts led to a soaring risk of inflation, which required more aggressive rate hikes to control inflation, ultimately leading to an economic recession.

3. Capital Outflows and Currency Depreciation

Fed interest rate cuts usually reduce the interest rate advantage of the U.S. dollar, leading to capital outflows from U.S. markets to higher-yielding assets in other countries. This capital outflow can put pressure on the U.S. dollar exchange rate, leading to dollar depreciation. While dollar depreciation can stimulate exports to some extent, it may also bring the risk of import-driven inflation, especially when raw material and energy prices are high. In addition, capital outflows may also lead to financial instability in emerging market countries, especially those reliant on U.S. dollar financing.

4. Financial System Instability

Interest rate cuts are usually used to alleviate economic pressures and support the financial system, but they may also encourage excessive risk-taking. When borrowing costs are low, financial institutions and investors may seek higher-risk investments for higher returns, leading to the formation of asset price bubbles. For example, after the bursting of the 2001 technology stock bubble, the Fed significantly cut interest rates to support economic recovery, but this policy to some extent fueled the subsequent real estate market bubble, ultimately leading to the 2008 financial crisis.

5. Limited Effectiveness of Policy Tools

In the early stage of interest rate cuts, if the economy is already close to zero interest rates or in a low-interest rate environment, the Fed's policy tools may be limited. Overreliance on interest rate cuts may not effectively stimulate economic growth, especially when interest rates are close to zero, requiring more unconventional monetary policy tools, such as quantitative easing (QE). In 2008 and 2020, after the Fed cut interest rates close to zero, it had to adopt other policy tools to address economic downturns, indicating that the effectiveness of interest rate cuts is limited in extreme situations.

Looking at historical data, since the end of the Cold War in the 1990s and the world entering a U.S.-dominated global political landscape, the Fed's monetary policy has reflected a certain degree of lag. Currently, with the intensifying confrontation between the U.S. and China, the breakdown of the old order undoubtedly exacerbates the uncertainty and risks of policies.

Inventory of Major Risks in the Current Market

Next, let's take stock of the major risks in the current market, focusing on the risk of a U.S. recession, the pace of interest rate cuts, the Fed's Quantitative Tightening (QT) plan, the risk of reigniting inflation, and the efficiency of global central bank coordination.

Risk One: Risk of U.S. Economic Recession

Many people have referred to the potential interest rate cut in September as a "defensive rate cut" by the Fed. Defensive rate cuts refer to interest rate cut decisions made to reduce potential economic recession risks when economic data has not significantly deteriorated. In my previous article, I have analyzed that the U.S. unemployment rate has officially triggered the "Sam rule" for the recession. Therefore, it is extremely important to observe whether the interest rate cut in September can curb the gradually rising unemployment rate and stabilize the economy.

Let's take a closer look at the specific details of the non-farm employment data. It can be seen that in the category of commodity production, manufacturing employment has shown a long period of low-volatility fluctuations, with the construction industry contributing more to the data. For the U.S. economy, high-end manufacturing, along with its associated technology and financial services, are the main driving forces. This means that when this high-income elite group's income rises, they increase consumption due to the wealth effect, benefiting other middle and low-end service industries. Therefore, the employment situation of this group can serve as a leading indicator of overall U.S. employment. The weakness in manufacturing employment may present a certain risk. In addition, let's look at the U.S. ISM Manufacturing Index (PMI), which is rapidly declining, further confirming the weakness in U.S. manufacturing.

Next, let's look at the service industry, where professional and technical services and retail are both experiencing a similar freeze. The main contributors to the indicators are mainly in education, healthcare, and leisure and entertainment. The main reasons for this, in my opinion, are twofold. Firstly, there has been some recurrence of COVID-19 recently, and due to the impact of hurricanes, there has been a shortage of related medical personnel. Secondly, as most Americans were on vacation in July, the growth in tourism and other leisure and entertainment industries was driven by the holiday period. When the holiday period ends, this sector is bound to suffer a certain setback.

Therefore, overall, the risk of a U.S. recession still exists, so it is necessary for everyone to further observe related risks through macro data, mainly including non-farm employment, initial jobless claims, PMI, Consumer Confidence Index (CCI), and housing price index.

Risk Two: Pace of Interest Rate Cuts

The second issue to focus on is the pace of interest rate cuts. Although the start of interest rate cuts has been confirmed, the speed of the cuts will affect the performance of the risk asset market. Historically, emergency interest rate cuts by the Fed have been relatively rare, so market interpretation between monetary policy meetings will influence price trends. When certain economic data indicates that the Fed is raising rates too slowly, the market will react first. Therefore, it is crucial to determine an appropriate pace of interest rate cuts and guide the market according to the Fed's goals through interest rate guidance.

The current market's estimate for the September interest rate decision is a nearly 75% probability of a 25-50 basis point cut, and a 25% probability of a 50-75 basis point cut. Therefore, closely monitoring the market's judgment can also clearly assess market sentiment.

Risk Three: QT Plan

Since the 2008 financial crisis, the Fed rapidly lowered interest rates to 0 but still did not see economic recovery. At that time, monetary policy had become ineffective because further interest rate cuts were not possible. To further inject liquidity into the market, the Fed created the Quantitative Easing (QE) tool, injecting liquidity into the market by expanding the Fed's balance sheet and increasing the size of the bank system's reserves. This method essentially shifted market risk to the Fed. Therefore, to reduce systemic risk, the Fed needs to control the size of its balance sheet through Quantitative Tightening (QT) to avoid excessive loose policies leading to excessive risk.

Powell's speech did not address the current QT plan judgment and subsequent planning, so we still need to maintain a certain level of attention to the progress of QT and the resulting changes in bank reserves.

Risk Four: Risk of Reigniting Inflation

Powell maintained an optimistic attitude towards the risk of inflation at the Friday meeting, although it has not reached the expected 2%, there is already confidence in controlling inflation. Indeed, this judgment can be reflected in the data, and many economists have begun to suggest that setting the target inflation rate at 2% after the baptism of the pandemic may be too low.

However, there are still some risks:

1. From a macro perspective, the re-industrialization of the United States is not smooth due to various factors, and the U.S.'s anti-globalization policy against the backdrop of U.S.-China confrontation has not fundamentally resolved supply-side issues. Any geopolitical risk will exacerbate the reignition of inflation.

2. Considering that the U.S. economy has not entered a substantial recession cycle in this round of rate hikes, with the progress of interest rate cuts, the risk asset market will experience a recovery. When the wealth effect reoccurs, with the expansion of demand, service industry inflation will reignite.

3. Finally, there is a statistical issue. We know that to avoid seasonal factors from disturbing the data, CPI and PCE data are usually expressed in year-on-year growth rates to reflect the real situation. Starting from May this year, the high base period factor of 2023 will be exhausted. At that time, the performance of related data will be easily influenced by growth.

Risk Five: Efficiency of Global Central Bank Coordination

I believe most people still remember the risk of the yen-dollar interest rate differential trading in early August. Although the Bank of Japan immediately stepped in to calm the market, we can still see from the testimony of BoJ officials in the past two days that they have a hawkish attitude. Moreover, during their speeches, the yen experienced a significant rise, which was then restored after officials reassured the market. In reality, Japan's macro data performance does indeed require a rate hike, as I have detailed in a previous article. However, as a core source of global leveraged funds for a long time, any dinner party by the Bank of Japan will bring great uncertainty to the risk market. Therefore, it is necessary to maintain a high level of attention to its policies.

Risk Six: U.S. Election Risk

Finally, it is necessary to mention the risk of the U.S. election. I have already provided a detailed analysis of Trump's and Harris's economic policies in previous articles. As the election approaches, there will be more and more confrontations and uncertainties, so it is necessary to constantly keep an eye on election-related matters.

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