Fed's Interest Rate Cut on the Horizon?

The Federal Reserve has been at the center of discussions regarding interest rates this year, stirring considerable interest and speculation among market participantsThe interplay between the Fed and various market institutions over interest rate cuts has not only been pivotal for the U.Sstock market but has had ramifications on a global scale.

In the early hours of May 2nd, Beijing time, the Federal Reserve announced that it would maintain the federal funds rate target range at 5.25% to 5.50%. This marks the sixth consecutive meeting where the Fed has opted to press the "pause" button on rate cuts, keeping the interest rate at levels not seen in over twenty years.

Current market consensus indicates that the Fed is hesitant to initiate a rate-cut cycle until there is clear and compelling evidence that inflation has been effectively brought under control.

Prior to this decision, some analysts had speculated that the Fed might lower rates for the first time this year in November

However, the release of the April jobs report has seemingly altered these expectations.

On Friday, May 3rd, just before the market opened, the U.Slabor market report revealed that non-farm payrolls in April were only 175,000, a dramatic drop of over 40% from March's 315,000, far below market expectationsIn light of this, some investors began to predict that the Fed might soon commence a rate-cutting agenda.

According to the latest data from the Chicago Mercantile Exchange's FedWatch tool, investors currently assign a 69.4% probability that the Fed will cut rates by at least 25 basis points in September.

In conjunction with their announcement to leave rates unchanged, the Fed indicated it would scale back on quantitative tightening (QT). Beginning in June, the Fed plans to decrease its monthly U.S

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Treasury bond sales from $60 billion to $25 billion.

Analyst Zhang Jun from China Galaxy Securities noted that on one hand, persistent inflation pressures in the first quarter and a tight labor market have raised concerns within the Fed that any premature interest rate cuts could lead to a resurgence in inflationOn the other hand, a noticeable economic slowdown suggests that reducing the balance sheet might alleviate upward pressure on long-term interest rates.

Zhang further indicated that maintaining high interest rates while adjusting the pace of balance sheet reduction could strike a balance between controlling inflation and preventing recession

Optimistically, as inflation is expected to moderate in the second and third quarters of this year, the possibility of two rate cuts by the end of the year still remains viable.

"The Fed is not completely closing the window on rate cuts this year; rather, it is likely to delay their timing, requiring more data for validation," claimed a report from Dongwu SecuritiesWhile rate hikes remain an option, the threshold for such actions will be higher, particularly as the Fed acknowledges potential systemic misjudgment regarding inflation.

Based on prior assessments regarding a likely weak "re-inflation" in the coming one to two quarters, Dongwu Securities concluded that the urgency for an immediate rate cut in September is minimal, with inflation unlikely to consistently decline over five months

Nonetheless, the possibility of at least one rate cut in the year remains plausible.

During discussions, Chairman Jerome Powell mentioned three potential scenarios the Fed could face, two of which indicate the likelihood of rate cuts, suggesting the Fed remains inclined to lower rates this year, should conditions not worsenThe paths include sustained inflation above target with an overheated job market, necessitating confidence to avoid lowering rates; a scenario in which inflation begins to decline; and an unexpected weakening in the labor marketAlthough the hurdles for triggering rate cuts have increased compared to the first quarter meeting, Powell's assumptions still lean towards rate cuts being more of a baseline scenario.

Analyst Qin Tai from Huajin Securities observed that in the context of the current U.S

economic landscape, slowing down the balance sheet reduction while maintaining high interest rates aligns closely with their long-term goal of curbing inflation.

Two layers of logic are essential to considerFirst, by slowing down the pace of balance sheet reduction, the Fed aims to stabilize long-term real interest rates, promote high investment and output growth, narrow the demand gap, and thereby reduce inflationSecond, by lowering the proportion of MBS (mortgage-backed securities) held by the Fed, they can maintain restrictive mortgage rates to prevent a potential overheating of the real estate market during a future rate-cut cycle, thereby moderating inflation from housing prices and rents.

Moreover, industry insiders have pointed out that the stagnation of potential rate cuts by the Fed can be attributed to the lack of optimistic data surrounding the U.S

economy, as growth rates fall short of expectations while inflation remains stubbornly high.

Currently, signs of an economic slowdown have begun to emerge in the United StatesIn the first quarter, the annualized growth rate of U.Sreal GDP was only 1.6%, which is below the expected 2.5% and the lowest growth rate since the second quarter of 2022.

Reports from the China Galaxy Securities Research Institute indicate that there are also signs of a cooling economy in the U.SIn April, the manufacturing PMI (Purchasing Managers' Index) finalized at 50, slightly above expectations and the initial value of 49.9, but still far below the previous value of 51.9. The service sector, which contributes more to the economy, also did not meet expectations, recording an initial value of 50.9, although it remains above the expansion threshold, it is significantly lower than the expected 52 and previous value of 51.7. The composite PMI still indicates expansion but came in at 50.9, again below the expected 52 and the prior value of 52.1.

"Less wild fluctuations and more focus on fundamentals," urges the Dongwu Securities report, indicating that if the Fed can maintain stability, it may not necessarily be detrimental to the market