Abstract

The Federal Reserve has initiated the latest round of interest rate cuts, so how soon will the economy recover, and how will assets perform?

Historically, a good start often corresponds to a faster recovery. Before the start of this round of interest rate cuts, residents had more cash, lower debt, low real estate vacancy rates, and an upward financial cycle, which may accelerate the pace of economic recovery in this round. Based on the quantitative analysis of all 17 interest rate cut cycles in the United States since 1965, we estimate that the U.S. economy will rebound around 4-5 months after this round of interest rate cuts. In fact, before the interest rate cuts even began, influenced by the expectation of rate cuts and fiscal efforts, there were signs of stabilization in U.S. consumption, real estate, equipment investment, corporate capital expenditure, and inventory cycles, and high-frequency labor market data also showed positive signals.

We believe that strong economic resilience, coupled with fiscal and monetary easing, will lead to a faster recovery, resulting in a relatively short interest rate cut cycle, mainly benefiting corporate profits, while the pull on valuations is relatively limited. Assets will show more pro-cyclical characteristics (see "The Economic Logic of 'Shallow Rate Cuts' and Asset Mainlines"). The U.S. stock market is likely to continue its upward trend, but the style is expected to shift from large-cap growth to pro-cyclical, with two main lines worth paying attention to: 1) the consumer discretionary sector related to consumer resilience; 2) the industrial sector and the upstream raw materials and energy sectors related to the upward cycle of investment and manufacturing. U.S. Treasury bonds will continue to steepen, with long-end interest rates rising, and the 10-year U.S. Treasury rate may rise to around 4.2% by the end of the year to the second quarter of next year, with the pace affected by economic data. In commodities, copper and oil may synchronize with the economic recovery, and are greatly influenced by the recovery of the Chinese economy. Gold may continue to rise, but the financial investment increase driven by the decline in real interest rates before the rate cut will slow down, and demand is mainly supported by central bank gold purchases stimulated by geopolitical turmoil.

Advertisement

Main Text

The new round of interest rate cuts by the Federal Reserve has begun, how will policy, economy, and assets perform afterwards? Historically, shallow rate cuts correspond to fast recoveries, such as in 1995, when the federal funds rate was lowered by 75 basis points, corresponding to the economy warming up three quarters after the rate cut; while deep and longer rate cuts correspond to slow recoveries, such as from 2007 to 2008, when the rate was lowered by 500 basis points, and the economy only improved after nine quarters. Behind the different performances is a unified logic, the direction of the economy after rate cuts depends on the health of the economic fundamentals at the start of the rate cuts. In 1995, when the rate cuts began, the economy had strong internal momentum, while in 2007, before the rate cuts, the U.S. fell into a subprime crisis, with fragile internal momentum. So, how deep are the rate cuts in this round? How fast will the economy rebound?

Finding the Determinants of Recovery Rhythm: Quantitative Analysis Based on Historical Interest Rate Cut Cycles

Academic literature indicates that indicators related to household balance sheets [1] and real estate credit-related indicators [2] are key factors affecting the depth of recessions and the speed of economic recovery. These two major categories of indicators largely determine the resilience and internal momentum of the economy. Based on this, we use a linear single-factor regression model to conduct a quantitative analysis of all 17 interest rate cut cycles in the United States since 1965, examining economic aggregate indicators, labor market indicators, real estate indicators, and inflation indicators [3], to explore the impact of different initial values of economic resilience indicators on the pace of economic rebound after rate cuts.

The results show that the ratio of household cash to total assets, the ratio of household debt to net assets, and the real estate vacancy rate, these three initial economic indicators have a significant impact on the variable of economic rebound after rate cuts. The larger the ratio of cash held by the household sector to total assets, the lower the debt leverage ratio, the greater the potential for consumer spending after rate cuts, and the faster the economic rebound; the lower the real estate vacancy rate, the less the bubble tends to be. In addition to the above three indicators, BIS research shows that the economy in the first half of the financial real estate cycle [4] often suppresses the economic downturn and amplifies the economic upturn [5].

The current state of these indicators indicates a faster recovery rhythm after the start of rate cuts. The ratio of household cash to total assets is positively correlated with economic rebound, with the current value at the 72.1% percentile in the full data sample since 1960, and the 82.9% percentile in the initial sample of rate cut cycles [6], at a historical high; the ratio of household debt to net assets is negatively correlated with economic rebound, with the percentile in the historical full sample at 18.1%, and the 9.4% percentile in the rate cut cycle sample, at a historical low; the real estate vacancy rate is negatively correlated with economic rebound, with the current value at the 9.1% percentile in the historical full sample, and the 0.0% percentile in the initial sample of rate cut cycles, at a historical low; finally, in the first half of the financial cycle, the U.S. economy often lands softly or rebounds quickly, and the U.S. is currently in the first half of the financial cycle.To quantify the time it takes for the economy to rebound after the current round of interest rate cuts, we score the current values of the indicators based on the percentile they occupy in the initial sample of the interest rate cut cycle. The maximum score is 10 points. For indicators positively correlated with economic recovery, the initial resilience score = the percentile of the current value in the interest rate cut sample / 10; for indicators negatively correlated with economic recovery, the initial resilience score = 10 - the percentile of the current value in the interest rate cut sample / 10. Then, taking the scores of each initial resilience indicator as weights, we calculate the weighted average of the first significant rebound month for each indicator [7] as the number of months required for the economy to rebound after this round of interest rate cuts. From the results, we expect that the economy may show a more significant rebound about 4.5 months after the start of this round of interest rate cuts.

Historical Comparison: The Recovery in 1995

Based on the above four initial resilience indicators, the current economic fundamentals during this interest rate cut cycle are most similar to those before and after the interest rate cuts in 1995. Specifically, the current ratio of household cash to total assets is at a historically high position since 1965, similar to when the interest rate cuts began in 1995. The current ratio of household debt to net assets and the vacancy rate of real estate are both at historically low positions, similar to when the interest rate cuts began in 1995. At the same time, both the current period and 1995 are in the first half of the financial cycle. Therefore, we will review the performance of major macro-financial variables 12 months before and after the interest rate cuts in 1995 [8].

In terms of macroeconomic indicators, after the interest rate cuts began in 1995, the decline in the manufacturing PMI began to narrow and showed a significant upward trend after 6 months; the LEI rebounded rapidly after the interest rate cuts and continued its upward trend in the following 12 months; the total retail sales环比 began to rise before the interest rate cuts, and the core retail sales环比 exceeded the pre-interest rate cut growth peak after 10 months; private fixed asset investment year-over-year showed a certain upward trend after the interest rate cuts and accelerated rebound after 3 quarters; while residential fixed investment showed a significant "V-shaped" rebound trend after the interest rate cuts began.

In terms of real estate indicators, after the interest rate cuts began in 1995, new home sales quickly warmed up and continued their significant upward trend in the following 12 months; new home construction showed an accelerated rebound trend 6 months after the interest rate cuts began; the 30-year mortgage interest rate showed a trend of decline after the interest rate cuts began and rose after 9 months along with the end of the interest rate cut cycle; at the same time, the MBA purchase index quickly rose after the interest rate cuts began along with the decline of the 30-year mortgage interest rate.

Economic Restart, Cycle Continuation

A good start corresponds to a faster recovery. Moreover, the strength of fiscal policy at the beginning of this round of interest rate cuts is unprecedented. Since 2020, fiscal strength has basically determined the changes in the net worth of households and businesses, a situation that has never occurred in American history. In the face of unexpected growth in fiscal revenue, the Biden administration still increased the deficit through new exemption programs and postponed tax collection (see "CBO raises deficit rate, US fiscal policy re-empowers"). Since July, the fiscal deficit has widened significantly again, and we expect that the deficit scale in the fiscal year 2024 is expected to reach 2.05 trillion US dollars, with a deficit rate of about 7.1%.

Supported by the expectation of interest rate cuts and fiscal policy, the economy has gradually shown signs of stabilization before the start of this round of interest rate cuts. In terms of consumption and real estate, durable goods consumption环比has gradually warmed up since May, and the MBA purchase index has risen from the bottom since August along with the decline of mortgage interest rates. In terms of investment, the equipment investment cycle has restarted with the relaxation of bank commercial and industrial credit standards, and the S&P corporate capital expenditure环比has rebounded from the first quarter along with sales, among which the cyclical industries of industry and optional consumption show the most obvious signs of rebound, while the capital expenditure of the raw material industry maintains a high growth rate (see "Asset Implications of the Restart of the US Equipment Investment Cycle"). Driven by terminal demand, the inventory cycle continues and there is still a large space, and the inventory of various industries has bottomed out since the end of last year, and all have returned to positive growth in July. In the labor market that the Federal Reserve is most worried about, high-frequency data has also released positive signals. Since July, the number of continued unemployment benefits has begun to decline, and the Indeed job vacancy indicator has shown signs of bottoming out, especially in high-paying industries such as finance, technology, law, healthcare, etc., there has been a significant rebound.

We expect that due to the strong internal momentum of the current economy and the historically high fiscal deficit, the interest rate cut cycle will be more preventive and advanced, and asset performance will also be quite different from the deep interest rate cuts after 2007, 2020, etc. Specifically, corporate profits on the numerator side are expected to benefit more, while the room for valuation increase is limited, which is more beneficial to the cyclical style that we have been emphasizing for the past three months.U.S. stocks are likely to continue their trend of volatile upward movement (with high volatility still expected before the election), but the style will shift: from large-cap growth to value and cyclical stocks, that is, we are optimistic about the Dow outperforming the Nasdaq in the coming quarters. We highlight three main lines: 1) the consumer discretionary sector related to consumer resilience; 2) the real estate chain under low leverage, low vacancy rates, and low inventory; 3) the industrial sector and upstream raw materials and energy sectors related to the resumption of equipment investment and the manufacturing cycle. At the same time, we note that domestic export sectors and companies are also expected to benefit from these three main lines, such as hardware and plumbing, furniture and home furnishings, household appliances, as well as computer electronics equipment, industrial equipment, chemical products, and coal and petroleum products related to manufacturing and equipment investment (for details, see "Asset Implications of the Resumption of the U.S. Equipment Investment Cycle").

We expect U.S. Treasury yields to continue steepening, with long-end rates re-entering an upward channel in the fourth quarter (for details, see "U.S. Treasury Quarterly Report: Fiscal Efforts in the Third Quarter"). Short-end rates (T-bill rates) will gradually decline with rate cuts, and historically, unless a deep recession triggers Fed QE, long-end rates will rise after rate cuts. Given that the economy was relatively resilient at the start of this rate cut cycle, coupled with a large issuance scale of long-term bonds before the end of the year, we judge that long-end rates will continue to rise, with the 10-year U.S. Treasury rate potentially reaching 4.2%-4.5% by the end of the year to the second quarter of next year, with the pace affected by economic data.

Among commodities, copper and oil are expected to benefit from the synchronized recovery of China and the U.S., with copper having greater supply-side certainty. Historically, during periods of synchronized monetary and fiscal easing in China and the U.S., copper and oil often experience a bottoming and rebounding with the economic climate. We expect that against the backdrop of a faster economic rebound in the U.S. and increasingly clear and strong stimulative monetary and fiscal policies in China, the upward space for copper and oil has opened up, with copper facing more certain supply constraints and greater potential for upward movement. We are optimistic about gold continuing to shine under the new macro paradigm. Before the start of rate cuts, the decline in real interest rates drove an increase in financial investments (such as gold ETFs), and after rate cuts, we judge that there is limited room for long-end rates to decline or they may even return to an upward trend, which could weaken this demand. Gold prices will be more supported by central bank gold purchases, and recently, geopolitical turmoil in places like Russia and Ukraine, and the Middle East, may lead to a continued demand for central bank gold purchases.

The U.S. dollar index has limited room to decline. Currently, the U.S. economy is relatively stronger than Europe, and the Fed may cut rates less than the ECB, supporting the dollar; if Trump is elected, his trade protectionism and inclination to expand fiscal policy will further benefit the dollar. However, it should be noted that the market expects the Bank of Japan to raise rates by 25bps before the end of this year and next year, which could lead to a return flow of yen carry trade funds to Japan, exerting some downward pressure on the U.S. dollar index.