(Wang Hanfeng is the Managing Director of CICC)
Are there any other considerations and implications behind the unexpected shift of the Federal Reserve to strengthen market expectations for interest rate cuts? If that's the case, early interest rate cuts are still possible, but the subsequent path should not be linearly extrapolated, because relaxed financial conditions will lead to early recovery of demand, making it unnecessary for the Federal Reserve to cut so many times, and the market will also "turn back" between the two. In this article, we will further explore the possible implications of this unexpected change from a fiscal perspective, as well as its impact on the market.
1、 Understanding monetary policy from a fiscal perspective: 20% of treasury bond matures in 1Q24, and the interest rate will not fall, which will drive up the replacement cost of high debt and the interest rate will rise in 2023, making the US financial interest payment pressure hit a new high since 1996. However, since 98% of the outstanding US debt is a fixed interest rate, the effective interest rate of 3.1% is significantly lower than that of enterprises and residents. In 2024, especially in the first quarter, there will be a peak in debt maturity and replacement, and if interest rates remain high, it will push up replacement costs.
2、 The "benefits" of the Federal Reserve's unexpected turn: annual savings in interest expenses exceeding $70 billion, and an increase in the scale of long-term bond issuance
Based on the calculation of the $5 trillion maturity scale in the first quarter, if the 10-year US Treasury bond interest rate drops to 3.5%, it may save $76 billion in interest expenses annually, equivalent to 12% of the 2023 fiscal year interest expenses, accounting for 1.2% and 1.7% of overall fiscal expenditure and revenue. In fact, with the rapid decline in US bond rates, the issuance of long-term bonds has begun to rise recently, with an average issuance rate of 4.3%.
3、 The impact of early interest rate cuts on the market: Early rate cuts are still possible, bond gold is temporarily suspended but the trend remains unchanged, and there is greater risk after one or two cuts. It is still possible to start early rate cuts, and the subsequent path is highly uncertain. On the one hand, premature relaxation of financial conditions will lead to an early improvement in demand, reducing the possibility of rapid and continuous interest rate cuts; On the other hand, the replacement pressure of treasury bond due after the first quarter decreased. This means that the Federal Reserve can choose to pause and observe after cutting interest rates a few times, and should not excessively linearly extrapolate the subsequent path. In this context, the market expects a "reversal run", with bond gold temporarily suspended but the trend unchanged, and the US stock market looking at the smoothness of switching from denominator to numerator logic.
At the December FOMC meeting, Federal Reserve Chairman Powell unexpectedly turned the tables, stating that "interest rate cuts have come into view", which surprised the market because just two weeks ago, he stated that discussions on interest rate cuts were not mature. It is this statement that strengthens the market's expectation of interest rate cuts, driving the US Treasury bond rate further down to 3.8%. If it weren't for this change, market expectations would not have rushed to this point. CME futures are expected to start cutting interest rates in March and cut interest rates six times a year by 150bp. The expectation of this overdraft has also become the core reason for the recent rebound in US bond rates and the US dollar under slightly improving data. We have been reminding that from a fundamental perspective alone, we do not support the Federal Reserve cutting interest rates too quickly ("What would happen if the Federal Reserve cuts interest rates early?"), and recent real estate and employment data also confirm this.
However, what confuses and doubts investors is whether the Federal Reserve saw something that the market had overlooked before making this unexpected turn, or whether there were other considerations and "profound implications"? If that's the case, it is still possible to cut interest rates early, but the path and frequency of future rate cuts cannot and should not be linearly extrapolated, because an early decline in financial conditions will lead to an early recovery of demand, making it unnecessary for the Federal Reserve to cut rates so many times. The market will also "turn back" before the two, similar to 2023.
We analyzed the possible reasons for the Federal Reserve to cut interest rates early in "How Does the Federal Reserve Cut Interest Rates?". In this article, we further explore the potential implications of this unexpected change by the Federal Reserve from a fiscal perspective, as well as its impact on the market.
1、 Understanding monetary policy from a financial perspective: nearly 20% of treasury bond will expire in 1Q24, and the replacement cost will be increased if the interest rate does not fall
High debt has put the pressure on US fiscal interest payments at a new high since 1996. Since the outbreak of the pandemic, several rounds of large-scale fiscal stimulus by the US government have increased the government's debt scale, which once swelled to $20 trillion and reached a peak of 130% of GDP in the second quarter of 2020, gradually falling back to 113% in the first quarter of 2023. However, the good times are not long. In the first half of 2023, the risk exposure of small and medium-sized banks and the lifting of the debt ceiling made the US government credit expand again, and the leverage ratio further rose to 116%, which is also the core reason for the surge of US debt in 2023. The scale of treasury bond held by the public expanded to $26 trillion.
In addition to the increase in scale, the rise in interest rates in 2023 has also significantly increased the pressure on fiscal interest payments. The interest expense for the fiscal year 2023 was $660 billion, an increase of 39%, accounting for 11% of the total fiscal expenditure, reaching a new high since 2001; The proportion of fiscal revenue has risen to 17%, a new high since 1996. However, since 98% of US treasury bond are fixed rate bonds, the effective interest rate of treasury bond in stock at present is 3.1%, which is significantly lower than that of enterprises (the effective interest rate of corporate bonds is 4%, the effective interest rate of industrial and commercial credit is 6.3%, and that of small enterprises is 7.2% higher) and residents (3.7%). However, the huge scale makes its interest payment pressure rise to a historical high faster (Detailed Interpretation of Financing Costs and Burden of Various Departments in China and the United States).
In 2024, especially in the first quarter, there will be a peak in debt maturity and replacement, and if interest rates remain high, it will push up replacement costs. Compared with the maturity scale of US $10.6 trillion in 2023, there are still up to US $8.6 trillion of treasury bond due in 2024 (excluding the short-term debt due within the year), which is equivalent to 35% of the stock scale of US $26 trillion. Among them, the maturity scale in the first quarter alone reached $5 trillion, equivalent to 54% of the maturity scale in 2024 and 19% of the overall stock. This means that if interest rates remain high at 5% without lowering, the cost for the US Treasury to issue both short-term and long-term bonds (which are less cost-effective due to interest rate locking effects) will have to rise from the current effective interest rate of 3.1% to around 5%.
Although theoretically the US government can still solve this problem by raising the debt ceiling, in the long run, excessive interest payment pressure will inevitably affect its fiscal health and increase uncertainty in the political environment of intense competition between the two parties in election years. At the same time, excessive interest expenses can also squeeze out other fiscal expenditures, and even cause the overall fiscal deficit to exceed expectations (interest rate expenditures are non discretionary expenditures that are not subject to budget laws) ("Where has the US credit cycle gone?").
2、 The Federal Reserve unexpectedly turns to "benefits": it saves over $70 billion in interest expenses annually, and the scale of long-term bond issuance has increased
Understanding the current pressure on US fiscal interest payments and the massive scale that is about to expire in the first quarter, it is not difficult to understand US Treasury Secretary Yellen's "call" before the December FOMC meeting that "inflation will continue to decline, trust the Federal Reserve's decision, but policy interest rates will also naturally decline.". It is not difficult to understand that, if there is any "profound meaning", the benefits of the Federal Reserve's expectation management of lowering US Treasury interest rates in saving fiscal costs.
Annual savings in interest expenses exceed 70 billion US dollars. In theory, if the current market interest rate further drops by about 3%, which is equivalent to the effective interest rate of 3.1% of the stock treasury bond, the replacement cost of treasury bond due from the Ministry of Finance will not increase. Based on the scale of $5 trillion of treasury bond due in the first quarter, if the 10-year treasury bond is reduced to 3.5%, the annual interest payment cost will be saved by $76 billion, equivalent to 12% of the interest expenditure in fiscal year 2023, accounting for 1.2% of the overall fiscal expenditure and 1.7% of the overall fiscal revenue.
The issuance scale of long-term treasury bond has risen recently. In fact, we have noticed that with the rapid decline in US bond rates, long-term bond issuances have begun to rise recently, with an average issuance rate of 4.3%. After the interest rate peak fell in October, long-term treasury bond issued US $151 billion accumulatively in less than two months, accounting for 19% of the total issuance of long-term bonds in 2023. Among them, the 10-year treasury bond was $77 billion, the 20-year treasury bond was $29 billion, and the 30-year treasury bond was $45 billion.
3、 The impact of early interest rate cuts on the market: Early cuts are still possible, bond gold is temporarily suspended but the trend remains unchanged, and the risk increases after one or two cuts
It is still possible to lower interest rates ahead of schedule, but the subsequent path cannot be linearly extrapolated, and the risk is greater after one or two cuts. Considering the cost savings of bond issuance and other considerations mentioned in "What would happen if the Federal Reserve cuts interest rates early?", it is still possible for the rate cut to start early, as the FOMC has already turned in December. Therefore, the end of January FOMC will be an important verification point.
On the contrary, the subsequent path is more uncertain, especially after a few drops. On the one hand, the fundamentals themselves are not that bad, and the early easing of financial conditions will lead to an improvement in demand, which will actually reduce the possibility of continuous and rapid interest rate cuts. The recent slight improvement in real estate data is evidence. On the other hand, after the first quarter, the maturity scale will rapidly decline, and the pressure of replacement will also significantly decrease. Even if the Federal Reserve considers "helping" fiscal cost savings, the urgency will not be as great at that time. This means that if demand improves or even inflation rises more significantly at that time, the Federal Reserve can choose to pause and wait after lowering interest rates a few times, and should not excessively linearly extrapolate the subsequent path.
The market is "turning back and running", bond gold is temporarily suspended but the trend remains unchanged, and the US stock market is looking at the smoothness of switching from denominator to numerator logic. In fact, similar situations have occurred multiple times in 2023, with the market experiencing expected interest rate cuts → interest rate declines → growth and inflation repairs → expected interest rate hikes warming → interest rate hikes → growth and inflation declines. This cycle fluctuates and "runs back and forth" repeatedly, but with a much larger range and duration, with the low point as 3.3% and the high point as high as 5%.
In this context, the long-term US Treasury and gold driven by interest rate cuts may be temporarily delayed due to excessive expectations of "grabbing" in the short term, but the direction has not reversed, at least until after one or two initial interest rate cuts. We estimate that the long-term bond center is 3.5%~3.8%, with short-term bonds outperforming long-term bonds. The US stock market will also experience ups and downs during this period, with pressure estimated to be around 10% from a financial liquidity perspective.
But once the effect of interest rate cuts on demand improvement is reflected, the long-term US bond rates and the US dollar will gradually bottom out (102-106), and the value of gold will also decrease (central $2100/ounce), while US stocks will shift from denominator logic to numerator logic, opening up a new logic.
Whether there will be any twists and turns in this process depends on the smoothness of switching from the denominator to the numerator. For example, switching was smoother in 1994, there were slight twists and turns in 2019, and there were greater fluctuations in 2023. Currently, similar to early 2019, the main risk comes from the fluctuation of inflation. If the Federal Reserve cuts interest rates too quickly and unexpectedly exerts fiscal power, it is possible that demand and inflation will fluctuate more than expected, and the "turnaround" will also be faster, similar to the third quarter of 2023.
Market dynamics: In December, the US ISM manufacturing PMI rose, while the service industry PMI fell, exceeding expectations for non farm payroll; US bond interest rates have rebounded, leading to a dual kill between stocks and bonds
? Asset performance: bulk> Debt> Stock; Kill both stocks and bonds. At the beginning of this week, the December ISM manufacturing PMI in the United States rebounded month on month, suppressing expectations of interest rate cuts. US bond rates rebounded to above 4.0%, and US stocks fell due to the drag of technology stocks. Subsequently, the statement of the December FOMC meeting minutes released by the Federal Reserve fell short of market expectations, combined with the December non farm payroll data released on Friday that exceeded expectations, driving the US Treasury bond interest rate to above 4.1% in the short term. However, the subsequent month on month decline in the ISM service sector PMI further pushed the US Treasury bond interest rate down. On the US stock market, the Nasdaq and S&P narrowly rebounded on Friday, but closed lower throughout the week. The three major stock indexes ended their nine week streak of gains.
? Liquidity: The onshore USD liquidity has tightened. In the past week, the OIS-SOFR spread has risen to 27bp, with credit spreads on US high-yield bonds and investment grade bonds widening. Cross swaps between Swiss francs, euros, and pounds and the US dollar have widened, while cross swaps between Japanese yen and the US dollar have narrowed. The degree of inversion of the 2s10s and 3m10s spreads has also narrowed. The usage of reverse repo by major US financial institutions on the Federal Reserve's books has declined, with current usage of 0.93 trillion US dollars per day.
? Emotional position: Emerging to net short. Over the past week, US and European stocks have returned to a reasonable range. An increase in speculative net short positions in US stocks; Emerging to net short positions; A decrease in net long speculative positions in the US dollar; Speculative net long positions in gold increased; The net short position of 2-year US bonds decreased, while the net short position of 10-year US bonds increased.
? Capital flow: The inflow of bonds and monetary funds is accelerating, while the inflow of stocks is slowing down. In the past week, the inflow of bonds and money market funds has accelerated, while the inflow of equity funds has slowed down. From a market perspective, among the major stock markets, inflows from emerging markets and China have accelerated, inflows from the United States have slowed down, inflows from Japan have shifted, and outflows from developed Europe have slowed down.
? Fundamentals and policies: The US ISM manufacturing PMI rose in December, while the service industry PMI fell; Non agricultural exceeding expectations
The US ISM manufacturing PMI in December rebounded to 47.4 month on month, but remained in a contraction range for 14 consecutive months; Looking at the sub items, the forward-looking new orders have fallen month on month, reflecting the gradual suppression of high interest rates on domestic demand. However, there has been an improvement in hand orders and export orders, and a strengthening external demand may form support. Inventory and prices continue to fall, consistent with the direction of easing inflationary pressures.
In December, the PMI of the ISM service industry continued to decline to 50.6 month on month, but remained in the expansion range; Looking at the sub items, except for commercial activities and order inventory, all indicators have weakened comprehensively. The forward-looking new order sub items have fallen month on month, reflecting the gradual suppression of high interest rates on domestic demand. The employment sub items have fallen month on month, which may indicate that the supply-demand contradiction in the labor market still exists.
In December, non farm payroll exceeded expectations, with 1) 216000 new jobs added, an expected 175000, and a previous value of 199000 (initial value). By industry, education, health, and leisure hotels have seen the largest growth, while employment in transportation and warehousing has declined. 2) Unemployment rate and labor participation rate: Unemployment rate 3.7%, expected 3.8%, previous value 3.7% (initial value). The labor participation rate is 62.5%, expected to be 62.8%, with a previous value of 62.8% (initial value). 3) Hourly salary: 0.4% month on month, expected 0.3%, previous value 0.4% (initial value); YoY 4.1%, expected 3.9%, previous value 4.0% (initial value). This month's data generally exceeded expectations in various sub items, with an increase in new employment, lower than expected unemployment rate, and an increase in hourly wage growth rate. The combination of these factors indicates that the economy is not so weak, which is not conducive to the excessive expectation of interest rate cuts. This is consistent with our long-standing belief that the fundamentals do not support too fast interest rate cuts.
? Market valuation: The valuation of US stocks is slightly higher than the reasonable level of growth and liquidity. The current dynamic P/E of the S&P 500 at 19.3 times is lower than the reasonable level supported by nominal interest rates and high yield bond spreads (~19.2 times).
This article only represents the author's viewpoint