An overview of the risks to focus on during the early stages of the Federal Reserve's 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 "now is the time for policy adjustment. The direction forward is clear, and the timing and pace of interest rate cuts will depend on upcoming data, evolving prospects, and the balance of risks." This signifies a turning point in the Federal Reserve's tightening cycle that has lasted nearly three years. If macro data does not deviate from expectations, the first interest rate cut is likely to occur at the meeting on September 19. However, entering the initial phase of a rate-cutting cycle does not mean an immediate surge in the markets; there are still risks that warrant caution. Therefore, I summarize some key issues that need attention at this time, hoping to help everyone avoid certain risks. Overall, in the early stages of rate cuts, we need to focus on six core issues, including the risk of a U.S. recession, the pace of rate cuts, the Fed's QT (Quantitative Tightening) plan, the risk of inflation resurgence, the efficiency of global central bank coordination, and U.S. political risks.

Rate cuts do not necessarily mean an immediate rise in risk markets; on the contrary, they often lead to declines

The Federal Reserve's monetary policy adjustments have profound implications for global financial markets. Especially in the early stages of rate cuts, although rate cuts are typically seen as measures to stimulate economic growth, they also come with a series of potential risks. This means that rate cuts do not necessarily lead to an immediate rise in risk markets; rather, in most cases, they result in declines. The reasons for this situation can usually be categorized as follows:

1. Increased volatility in financial markets

Rate cuts are generally viewed as a signal of support for the economy and markets, but in the early stages of rate cuts, uncertainty and increased volatility may arise in the markets. Investors often interpret the Fed's actions differently; some may view rate cuts as reflecting concerns about economic slowdown. This uncertainty can lead to significant fluctuations in both the stock and bond markets. For example, during the financial crises of 2001 and 2007-2008, despite the Fed beginning a rate-cutting cycle, the stock market still experienced significant declines. This was due to investors fearing that the severity of the economic slowdown outweighed the positive effects of rate cuts.

2. Inflation risks

Rate cuts mean lower borrowing costs, encouraging consumption and investment. However, if rate cuts are excessive or prolonged, they may lead to rising 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 nearing full employment. Historically, in the late 1970s, the Fed's rate cuts led to a surge in inflation risks, necessitating subsequent aggressive rate hikes to control inflation, which in turn triggered an economic recession.

3. Capital outflows and currency depreciation

The Fed's rate cuts typically reduce the interest rate advantage of the U.S. dollar, leading to capital flowing from U.S. markets to higher-yielding assets in other countries. This capital outflow can put pressure on the dollar's exchange rate, causing it to depreciate. While a weaker dollar can stimulate exports to some extent, it may also bring about the risk of imported inflation, especially when prices for raw materials and energy are high. Additionally, capital outflows may lead to financial instability in emerging market countries, particularly those reliant on dollar financing.

4. Instability in the financial system

Rate cuts are often used to alleviate economic pressure and support the financial system, but they can also encourage excessive risk-taking. When borrowing costs are low, financial institutions and investors may seek higher-risk investments for greater returns, leading to the formation of asset price bubbles. For instance, after the tech stock bubble burst in 2001, the Fed significantly cut rates to support economic recovery, but this policy contributed to the subsequent housing market bubble, ultimately leading to the 2008 financial crisis.

5. Limited effectiveness of policy tools

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

Historically, as we look back to the 1990s, following the end of the Cold War and the emergence of a U.S.-led global political landscape, the Fed's monetary policy has reflected a certain degree of lag. Currently, amidst the intensifying U.S.-China confrontation, the fragmentation of the old order undoubtedly exacerbates the risks of policy uncertainty.

Identifying the main risk points in the current market

Next, let’s identify the main risk points currently present in the market, focusing on the risk of a U.S. recession, the pace of rate cuts, the Fed's QT (Quantitative Tightening) plan, the risk of inflation resurgence, and the efficiency of global central bank coordination.

Risk 1: U.S. economic recession risk

Many people refer to the potential rate cut in September as the Fed's "defensive rate cut." A defensive rate cut refers to a rate cut decision made to reduce potential recession risks without a significant deterioration in economic data. ++In my previous article, I analyzed that the U.S. unemployment rate has officially triggered the "Sam Rule" warning line for recession++. Therefore, whether the rate cut in September can curb the gradually rising unemployment rate and stabilize the economy against recession becomes extremely important.

Let’s examine the specifics of the non-farm employment data. In the goods-producing sector, manufacturing employment has shown prolonged low volatility, with construction contributing more to the data. For the U.S. economy, high-end manufacturing, along with its associated technology and financial services, is the main driving force. This means that when the income of this high-income elite class rises, their increased consumption, influenced by the wealth effect, benefits other mid- to low-end service industries. Thus, the employment situation of this group can serve as a leading indicator for the overall employment situation in the U.S. The weakness in manufacturing employment may indicate a certain ignition risk. Additionally, looking at the U.S. ISM Manufacturing Index (PMI), we can see that PMI is in a rapid decline trend, further corroborating the weakness in U.S. manufacturing.

Next, let’s look at the service sector, where professional technical services and retail also exhibit a similar frozen situation. The main contributors to the indicators are education, healthcare, and leisure and entertainment. I believe there are two main reasons for this: first, there has been a resurgence of COVID-19, and due to the impact of hurricanes, there has been a certain degree of shortage of medical personnel. Second, in July, most Americans were on vacation, leading to growth in tourism and leisure industries, which will inevitably face a certain setback once the holiday ends.

Therefore, overall, the risk of recession in the U.S. still exists, and friends need 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 2: Pace of rate cuts

The second issue to focus on is the pace of rate cuts. Although it has been confirmed that rate cuts will begin, the speed of these cuts will affect the performance of risk assets in the market. Historically, emergency rate cuts by the Fed are relatively rare, so economic fluctuations between meetings require market interpretations to influence price trends. When certain economic data suggest that the Fed is cutting rates too slowly, the market will react first. Therefore, determining an appropriate pace for rate cuts and guiding the market to operate according to the Fed's targets through interest rate signals is crucial.

Currently, the market estimates a nearly 75% probability of a 25-50 basis point cut and a 25% probability of a 50-75 basis point cut in the September rate decision. Therefore, closely monitoring market judgments can provide a clear indication of market sentiment.

Risk 3: QT plan

Since the 2008 financial crisis, the Fed quickly lowered interest rates to zero, but this did not lead to an economic recovery. At that time, monetary policy had become ineffective, as further rate cuts were not possible. To inject liquidity into the market, the Fed created the quantitative easing (QE) tool, expanding its balance sheet to inject liquidity into the market while increasing the reserves of the banking system. This approach essentially transfers market risk to the Fed, so to reduce systemic risk, the Fed needs to control the size of its balance sheet through quantitative tightening (QT) to avoid disorderly easing leading to excessive risks.

Powell's remarks did not address the current QT plan or future plans, so we still need to maintain a certain level of attention on the QT process and the resulting changes in bank reserves.

Risk 4: Resurgence of inflation risks

Powell maintained an optimistic attitude towards inflation risks during Friday's meeting. Although it has not reached the expected 2%, there is confidence in controlling inflation. Indeed, data reflects this judgment, and many economists have begun to suggest that after experiencing the pandemic, whether the target inflation rate of 2% is too low remains a question.

However, there are still some risks:

• First, from a macro perspective, the re-industrialization of the U.S. is not proceeding smoothly due to various factors, coinciding with the U.S. de-globalization policies amid U.S.-China confrontations. The supply-side issues have not fundamentally been resolved. Any geopolitical risks will exacerbate the resurgence of inflation.
• Second, considering that the U.S. economy has not entered a substantial recession during this rate hike cycle, as rate cuts proceed, the risk asset market will show signs of recovery. When the wealth effect re-emerges, with the expansion of demand, service sector inflation will also reignite.
• Finally, there are issues related to data statistics. To avoid seasonal factors interfering with data, CPI and PCE data are usually expressed in year-on-year growth rates to reflect the real situation. Starting in May of this year, the high base factor for 2023 will be exhausted. At that time, the performance of related data will be easily influenced by growth.

Risk 5: Efficiency of global central bank coordination

I believe most friends still vividly remember the risks associated with the Japan-U.S. interest rate differential trading in early August. Although the Bank of Japan quickly stepped in to reassure the market, we can still see its hawkish stance from Ueda's recent congressional hearing. Moreover, during his speech, the yen experienced a noticeable appreciation, which was restored after officials reassured the market again post-hearing. In fact, Japan's domestic macro data does indeed necessitate rate hikes, ++as I have detailed in a previous article++, but as a core source of global leveraged funds for a long time, any rate hike by the Bank of Japan will bring significant uncertainty to risk markets. Therefore, it is necessary to maintain a high level of attention to its policies.

Risk 6: U.S. election risk

Finally, it is important to mention the risks associated with the U.S. elections. In my previous articles, I have already provided detailed analyses of the economic policies of ++Trump++ and ++Harris++. As the elections approach, there will be an increasing number of confrontations and uncertain events, so it is essential to keep a close watch on election-related matters.