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In the anticipation of the market, the Federal Reserve has started a new round of rate cuts with an "unconventional" reduction of 50 basis points (bp), officially ending the tightening cycle that began in early 2022.

The advantage of this "unconventional" rate cut is its swift response to "potential but not yet evident" growth pressures, but the downside is that it can easily lead the market to worry about "confirming" recession fears.

After all, "unconventional" rate cuts are usually extraordinary measures for extraordinary times, such as the 2001 internet bubble, the 2007 financial crisis, and the 2020 pandemic.

Fortunately, Federal Reserve Chairman Powell has created an image of being "ahead of the market," ready to do more at any time, but not urgently driven by recessionary pressure, by emphasizing that there are no signs of recession, that one cannot linearly extrapolate the path of rate cuts, that the natural rate is higher than historical levels, and that the dot plot path is more moderate than market expectations.

The market did not view the 50 bp rate cut as a "last resort" after a significant increase in recessionary pressure.

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The asset performance showed a combination of "sufficient easing but not bad growth," reflected in risk assets, especially growth styles leading the rally.

Because of this, the next few economic data points are crucial and will directly determine the path of rate cuts in the remaining two meetings of the year, as well as the balance between recession trades (U.S. Treasuries, gold), easing trades (both stocks and bonds bullish, growth stocks leading), and repair trades (late-cycle leading, such as real estate and industrial metals).

After the 50 bp rate cut in September, the Federal Reserve's dot plot indicates a 50 bp cut for the year, with a 200 bp reduction space for the entire cycle by 2026, which is significantly different from the CME futures expectation of a 75 bp cut within the year and a 200 bp cut by September 2025, with the latter being more aggressive.

So, how many times does the Federal Reserve need to cut rates, and how much is enough?

Where is the end of interest rates?

Answering this question is essentially answering when monetary policy will exit the "restrictive" range and when it will start to boost growth.

When will monetary policy exit the "restrictive" range?

The household sector has entered an easing state, and the tightening degree of the corporate sector and the overall economy has also narrowed rapidly.

How to measure whether monetary policy is "restrictive" is not to observe its absolute level but to compare it with the investment return rate of the economy, that is, to compare it with the interest rate level that each link of the economy can bear.

This round of rate cuts may have an effect faster than expected and normal historical experience, for the same logic as why rate hikes took a long time to suppress inflation, which may be that the investment return rate of the economy has already significantly increased (that is, the "neutral rate" mentioned by Powell is significantly higher than the pre-pandemic level).

In the first quarter of this year, the credit of the U.S. private sector was able to expand unexpectedly without rate cuts, on the one hand, because the monetary policy is not far from the boundary of the investment return rate and can quickly be reduced to the easing range; on the other hand, it is also because the financing costs of each link are based on the 10-year U.S. Treasury rate, which has fallen in advance due to rate cut expectations, without waiting for actual rate cuts.

From this perspective, after the full brewing of the recent rate cut expectations and the rapid decline of U.S. Treasury rates, we have noticed that the "restrictiveness" of monetary policy on the household sector has been basically lifted, and the constraints on the corporate sector and the overall economy have also narrowed rapidly.

Specifically, ► Household sector: Rate cut expectations and recession concerns have led to a significant decline in financing costs, which have turned to easing.

In the structure of household credit, housing mortgages account for 75%, so we use mortgage rates and rental returns as the measurement indicators of financing costs and investment returns for the household sector.

The 30-year mortgage rate is basically consistent with the 10-year Treasury rate trend.

The warming of rate cut expectations has led to a rapid decline in the 30-year mortgage rate, which has now fallen to 6.1% (as of September 19), significantly lower than the rental return rate of about 6.8%.

At the same time, the standards for bank residential loans in the third quarter have also turned to relaxation (the proportion of tightening-relaxation banks is -1.9%).

► Corporate sector: Financing costs have fallen and investment returns have rebounded, large enterprises are no longer restrictive, and the restriction degree of small and medium-sized enterprises has narrowed from 330bp to 250bp.

The financing channels of the corporate sector include both indirect financing (14% of commercial loans) and direct financing (40% of corporate bonds), with large enterprises more inclined to issue bonds, and small enterprises more dependent on bank credit.

In terms of financing costs, the high-yield and investment-grade credit spreads have fallen from the fourth quarter of 2023 to 3.24ppt and 1.25ppt, respectively, at the 30% and 15% historical percentiles.

Coupled with the significant decline in benchmark interest rates, the direct financing costs have fallen rapidly, with high-yield bond yields falling by 260bp (9.6% vs. 7%), and investment-grade bond yields falling by 163bp (6.6% vs. 5%).

The tightening standards for indirect financing of commercial loans have also fallen significantly, and the additional financing costs for small and medium-sized enterprises have fallen from 9% to 8.6%.

In contrast, the investment return rate has increased.

The ROIC of the S&P 500 has always been higher than the credit spread since this round of rate hikes, and it is still moderately upward, with the difference with the credit spread further widening, reflecting that the financing of large enterprises has not been suppressed.

The ROIC of the non-financial corporate sector has been repaired after two quarters, rising from 5.6% in the first quarter to 6.1% in the second quarter, and the difference with the additional financing costs of small and medium-sized enterprises has narrowed from 330bp in the first quarter to 250bp.

► Overall economy: The gap between the real interest rate and the natural interest rate has narrowed to below 70bp.

For the overall economy, the gap between the real interest rate and the natural interest rate (the level of the real interest rate when inflation and output gap are balanced) can be used as the degree of restraint and promotion of monetary policy on the economy.

In terms of financing costs, since the peak in April, rate cut expectations and concerns about growth have led the real interest rate to continue to fall from 2.3% to 1.6%.

The natural interest rate, which reflects the investment return rate, has also begun to rise.

The valuation of the natural interest rate varies under different models, and a relatively high-frequency and simple estimation method is to use the long-term interest rate of the Federal Reserve's dot plot minus the 2% target value of PCE, which has also risen to 0.9% since the second quarter (the long-term interest rates in March, June, and September were 2.7%, 2.8%, and 2.9%, respectively).

The difference between the two has narrowed from 117bp in the first quarter to 70bp, reflecting a certain degree of relaxation of the restraint on the overall economic level.

If calculated by the levels of the New York Fed and the Richmond Fed, this gap may be narrower.

In addition, financial conditions have also reached the most relaxed moment since the rate hikes in 2022.

The broader financial conditions can also be used as a supplementary indicator to assist in judgment ("The Threshold of the Federal Reserve's Rate Cuts"), which is composed of long-term interest rates, short-term interest rates, credit spreads, U.S. stocks, and the U.S. dollar.

Due to the large short-term fluctuation range of U.S. stocks, their impact on short-term changes in financial conditions is also more significant, which is also the main reason why U.S. stocks have driven the continuous easing of financial conditions this year.

As a high-frequency indicator, financial conditions are 2-3 months ahead of the economic surprise index, and the recent rise in the economic surprise index is the result of the relaxation of financial conditions in July; it is 1 month ahead of the inflation surprise index, and the tightening of financial conditions in August is reflected in the recent weakening of the inflation surprise index.

Where is the end of rate cuts and interest rates?

A 3.5% long-term bond rate can already stimulate demand, and further decline can activate the existing real estate market more.

In the overall economy and macro-sectors we discussed above, the current easing effects are all compared with "new" financing costs and investment returns to judge whether there has been a marginal improvement.

However, if financing costs fall further below the "existing" level, the interest pressure of various departments will be significantly improved, thereby stimulating the improvement of demand.

Here we assume that other conditions remain unchanged, and only rely on the decline of financing costs to infer the level of U.S. Treasury rates.

► Household sector: 3.2% can further stimulate existing demand.

As analyzed above, the current 3.7% U.S. Treasury rate has led the 30-year mortgage rate to fall below the rental return rate, stimulating marginal demand improvement, but more to attract first-time homebuyers.

Merely relying on the balance between investment return rate and financing costs cannot fundamentally solve the supply shortage of existing houses.

The owners of existing houses locked at lower interest rate levels have limited willingness to sell, resulting in low inventory and high housing prices, which in turn suppresses the home-buying ability of residents.

If the new mortgage rate is lower than the existing mortgage, it can further stimulate the demand for home purchases by residents.

By analyzing the existing mortgage structure, only 13% of the mortgage interest rates are above 6%, so the current financing cost of 6.1% is not entirely attractive and cannot effectively improve the current situation of supply and demand mismatch.

Moreover, the overdraft of home purchase demand after the epidemic has led to a weak willingness of residents to move, and only 25% of people have a tendency to replace under the condition of maintaining the original interest rate unchanged[1].

If the mortgage rate falls to 5%, the maximum proportion of potential listed homeowners can reach 22%, which may increase supply to a certain extent.

The 30-year mortgage rate and the 10-year U.S. Treasury rate do not change one to one, and the spread between the two has widened after the epidemic due to reasons such as spread inversion and the Fed's balance sheet reduction of MBS.

Assuming it returns to the average level of 180bp[2], the corresponding 10-year U.S. Treasury rate is about 3.2%.

► Corporate sector: The current interest rate level can already improve the existing interest pressure.

The disclosure time of the existing interest rate of commercial loans for indirect financing is relatively lagging, and the changes brought by the decline of U.S. Treasury rates and the Fed's rate cuts in the third quarter have not yet been announced.

Currently, the existing level in the second quarter is the same as the first quarter at 6.7%, and ROIC has increased from 5.6% in the first quarter to 6.1%, driving the gap between the two to narrow from 1.1ppt to 0.6ppt.

Because the commercial loan interest rate is highly related to the 10-year U.S. Treasury rate, we estimate that the current 3.6~3.7% U.S. Treasury rate basically corresponds to an effective interest rate of commercial loans of 5.3~5.5%.

Under the premise of growth repair supporting ROIC (6.1% in the second quarter), the overall corporate sector's existing financing costs may have fallen below the investment return rate in the third quarter.► Overall Economy: A 3.5% to 3.6% growth rate can essentially bridge the gap between the real interest rate and the natural interest rate.

As mentioned above, different models yield different estimates for the natural interest rate.

The LW model predicts a value of 1.22%, the HLW model predicts 0.74%, the Richmond Fed predicts 2.6%, the Federal Reserve predicts 0.9%, and the average is around 1.4%.

Currently, there is still a gap of 10 to 20 basis points between the actual interest rate and the natural interest rate.

If this gap is bridged, assuming inflation expectations remain unchanged, the real interest rate may drop to 1.4% to 1.5%, corresponding to a 10-year U.S. Treasury yield of approximately 3.5% to 3.6%.

What does this imply for assets?

A shift from loose trading to recession trading, with a gradual transition from denominator assets to numerator assets; short-term bonds, real estate chains, and industrial metals can gradually be focused on based on asset experience since the interest rate cuts since the 1990s.

The general rule shows that denominator assets perform better before interest rate cuts (such as U.S. Treasuries, gold, Russell 2000, and small-cap growth stocks represented by Hong Kong biotech stocks), and after the interest rate cuts, the effects of easing gradually become apparent, and numerator assets start to outperform (such as copper, U.S. stocks, and cyclical sectors) ("Interest Rate Cut Trading Manual").

However, each cycle is different, and different macroeconomic environments will lead to different asset trends and trading logics.

For example, in the 2019 interest rate cut cycle, after the first cut, U.S. Treasury yields gradually bottomed out, gold gradually topped out, and copper and U.S. stocks gradually bottomed out and rebounded, achieving a switch.

Therefore, in the context of a preference for the 2019 scenario as the benchmark, investors are advised to "think and act in reverse" at the current stage.

At present, an unconventional interest rate cut starting at 50 basis points will still cause the market to worry about whether future growth will face greater pressure in the short term.

Therefore, the next few economic data points are crucial and will determine the tilt between recession trading (U.S. Treasuries, gold), loose trading (stock and bond bull market, growth stocks leading), and repair trading (late cycle leading, such as real estate and industrial metals).

If the data does not deteriorate significantly, or even improves in some interest rate-sensitive sectors, such as real estate, as we expect, it will convey a combination to the market that "the degree of interest rate cuts is sufficient and the economy is not bad," achieving a new balance, and the subsequent market main line may turn to repair trading after interest rate cuts.

Therefore, in the current environment, U.S. Treasuries and gold still cannot refute this expectation, and there may still be some holding opportunities but limited short-term space.

If subsequent data confirm that the economic pressure is not significant, then these assets should be exited in a timely manner; in contrast, more certain are short-term bonds that directly benefit from Federal Reserve interest rate cuts, gradually repairing the real estate chain (even driving China's related export chain), and copper should also be gradually focused on, but it is still somewhat on the left side at present, and needs to wait for subsequent data to verify the "New Ideas for Interest Rate Cut Trading").