Federal Reserve: How much longer until a belated rate cut?

Dongwu Securities believes that the dot plot of the June FOMC meeting may still retain the possibility of a rate cut this year, but the timing of the rate cut may be postponed to the end of the year.

This time, the Federal Reserve "backed down," whether it's about rate cuts or rate hikes. Federal Reserve Chairman Powell, the "dovish" leader this year, frankly admitted that his confidence in inflation returning to a "sustained decline" this year has clearly decreased. Fortunately, the threshold for rate hikes has also been raised, and Powell has left a "crack" open for the possibility of rate cuts this year. After the market breathed a sigh of relief, the baseline scenario for policy pricing may gradually shift to the Federal Reserve's "inaction" this year—this may also be an important reason why US stocks rose sharply in the short term but ultimately closed slightly lower. Specifically, we believe that three key points should be grasped:

Inflation's stickiness was unexpected, but the door to rate cuts hasn't been completely closed. Compared to March, the May minutes acknowledged that inflation hadn't improved further in recent months ("a lack of further progress"), and the benign balance of strong employment and declining inflation last year has gradually disappeared this year. Of course, Powell still expects inflation to return to a downward trend this year, but his confidence in this has decreased.

Rate cuts are not easy, and rate hikes are even harder. The implementation of rate cuts still has two scenarios: one is a significant and unexpected cooling of the job market; the other is a resumption of a downward trend similar to last year's. Rate hikes are certainly an option, but the threshold will be higher—the Federal Reserve admits to a systematic misjudgment of inflation, which currently seems unlikely.

"Carrots beyond the stick," balance sheet reduction slower than expected. The May meeting announced that it would slow the pace of Treasury bond reduction from $60 billion per month to $25 billion starting in June, a reduction slightly higher than market expectations ($30 billion). Although this is more of a liquidity consideration, against the backdrop of the previously announced quarterly financing plan meeting expectations (bond supply will not have any unexpected problems for the time being), it is somewhat good news for the market.

Of course, we don't believe this meeting will "conclusively determine" the Fed's monetary policy for this year. Because the Fed officials have repeatedly flip-flopped on policy views since the pandemic, which is a major reason for significant asset volatility. US stocks just had their best start in five years, only to experience their worst monthly performance in six months. Perhaps it's time to reflect on the Fed's current policy adjustment model.

We believe the Fed's previous policy framework may have been too "hasty": given the stickiness of inflation and the resilience of the economy, the policy also needs more patience, "stickiness," and room for maneuver, especially considering the complexities of an election year. The tone of the May meeting may be a start. We believe that the June FOMC meeting dot plot may still retain the possibility of a rate cut this year, although the timing of the rate cut may be postponed to the end of the year.

"Three strikes and you're out." We believe that the three instances of prematurely "celebrating" since 2023 are an important reason why the Fed should shift to caution. Reviewing the history since the Fed's rapid tightening in 2022, Fed officials have shown three relatively clear "dovish" guidance periods, occurring in early 2023, mid-2023, and early this year, but all were reversed by the stickiness of inflation and the resilience of employment, leading to significant market volatility.

The temporary slowdown in the month-over-month inflation rate and the non-farm employment rate exceeding expectations is an important trigger. Reviewing the three periods, we can see that the slowdown in month-over-month inflation for the previous 2-3 months, falling to 0.3% or less, coupled with a "discount" in the strength of non-farm employment, is an important factor in catalyzing policy shift expectations and dovish statements from officials, which often leads to a rise in US stocks. However, this was invariably interrupted or reversed by a rebound in inflation and employment.

The "three strikes and you're out" principle may need to be broken, and the Fed may need a longer data confirmation window. Based on the above experience, the habit of a 3-month observation window may no longer be suitable, and we believe that extending the window to 4-6 months may be appropriate, which means stronger policy determination, rather than "reacting to every rumor."

June: Return to "inaction." Based on the above speculation, in the absence of an unexpected cooling of the job market or the outbreak of financial risks, this key juncture in June is rather delicate—inflation data for April and May (CPI) will also be released before the meeting. Our scenario analysis can refer to Figure 6:

Optimistic scenario: Month-over-month inflation in April and May continues to fall (or underperforms expectations), but it still cannot convince the Fed to cut rates. It is more likely that the dot plot will still maintain the possibility of 1-2 rate cuts this year.

Pessimistic scenario: Month-over-month inflation in April and May does not improve, and the median of the June dot plot may directly indicate that there will be no rate cuts this year. Rate hikes are certainly an option, but currently seem unlikely.

September: Election year, don't make any sudden moves. Compared to June, September may be a more sensitive policy node, as the Fed will be able to collect more comprehensive economic data (five months of inflation data), but there will also be more noise from external factors such as the election. In terms of the economy, the urgency of a direct rate cut in September is not great—inflation is unlikely to slow down for five consecutive months starting in April; at least yesterday's release of the April ISM PMI data shows that prices still have the momentum to accelerate month-over-month.

As for the interference of the election, the Fed's monetary policy may be affected, but it is not critical. Historically, whether or not there is a rate cut before the election does not seem to have a direct relationship with whether the ruling party can be re-elected. In the elections since the 1980s, three out of four rate cuts failed to lead to re-election. Ultimately, rate hikes and rate cuts reflect the state of the economy, and rate cuts due to a rapid economic slowdown are not good news for the ruling party. Perhaps more critical are issues such as immigration, government governance, and even the Palestinian-Israeli or Israeli-Iranian conflicts.

Of course, we have previously analyzed that a preemptive rate cut by the Fed before the election may be what the Biden administration wants most, but at least from the current economic logic, this is not urgent.

Market impact: Less volatility, more fundamental research. If the Fed can maintain its determination, it may not be a bad thing for the market: less market volatility caused by policy interference, less one-sided bets on policy, may allow investors to focus more on industry fundamentals and company fundamentals, which may be more beneficial to sectors and targets with better performance and well-established long-term logic.