China Galaxy Securities: The Federal Reserve held steady in May as expected, and a rate cut may require a longer wait

According to the Zhitong Finance APP, China Galaxy Securities released a research report stating that the Federal Reserve announced at the third FOMC meeting of the year to maintain the federal funds rate at 4.25%-4.50%, and continue to reduce the balance sheet through quantitative tightening (since April, the scale of Treasury bond repurchases has slowed from USD 25 billion/month to USD 5 billion/month), which is in line with market expectations. Since the May meeting does not provide economic projections and dot plots, the incremental information provided is limited, and the Federal Reserve is still inclined towards a "hard data dependence" path in the short term, which also means that interest rate cuts are unlikely to occur in the first half of the year.

Overall, the information conveyed in this meeting is not significantly different from March, except that after the announcement of reciprocal tariffs in April, the Federal Reserve faces greater uncertainty and stagflation risks. Although short-term officials are more reliant on hard data that has not yet weakened, looking at the whole year, with total demand likely contracting due to tariffs and government attempts to reduce spending, the Federal Reserve will still implement two to three interest rate cuts in the second half of the year, although the probability of the first rate cut occurring in July is also decreasing.

The main viewpoints of China Galaxy Securities are as follows:

The Federal Reserve's main concern remains stagflation, but internal views may be divided into two factions.

Overall, the Federal Reserve continues to emphasize the risk of "stagflation" in this meeting, focusing more on hard data that has not yet shown a significant decline, and has not provided clear guidance on the timing of interest rate cuts. After the implementation of reciprocal tariffs in April, which severely disrupted market expectations, soft data shows that short-term inflation expectations in the private sector have risen significantly, while the weakening of consumption and investment expectations also suggests a future rise in unemployment; on the other hand, first-quarter GDP and labor market data have not significantly weakened, and the impact of tariffs on economic growth inertia has yet to be reflected. In the absence of clarity on the extent of stagflation caused by tariffs in the U.S. in the first half of the year, Powell tends to remain inactive.

It is worth noting that there seems to be a division within the Federal Reserve regarding the impact of tariffs, with the first faction led by Powell, who is concerned about rising inflation and relies on hard data, while the other faction, represented by a small number of officials including Governor Waller, believes that inflation is temporary and that interest rate cuts should be initiated to hedge against significant deterioration in hard data.

Four aspects worth noting from this meeting:

(1) The significant uncertainty caused by tariffs has been further emphasized, and the Federal Reserve's concerns about stagflation have increased. The most notable change in the May FOMC meeting statement compared to March is the emphasis on the continued rise in uncertainty facing the economy due to the impact of reciprocal tariffs in April (Uncertainty about the economic outlook has increased further).

(2) Compared to soft data, the Federal Reserve's short-term observations rely on hard data, which also means that the probability of interest rate cuts in the first half of the year is low, and the likelihood of a rate cut in July is also decreasing. Among the views of the Federal Reserve's "two factions," the mainstream attitude is to cautiously observe hard data, prevent the risk of rising inflation, and not rush into interest rate cuts.

(3) Powell did not indicate which is more important to the Federal Reserve, inflation or labor data, nor did he provide clear guidance on the interest rate cut path, but the labor market may be more critical. (4) Compared to the Federal Reserve, tariff negotiations and fiscal policy are more important in the short term. Based on the historical duration of trade negotiations in the United States, the average time from the start of communication with the U.S. to the final signing of a free trade agreement was 18 months for 2016 and earlier, with the shortest being 4 months. This also means that substantial and widespread progress in this round of tariff communications may not be achieved until at least the third quarter.

What are the impacts of two potential interest rate cut paths on asset prices?

In terms of the market, CME data shows that the expectations for interest rate cuts among federal funds futures traders remain relatively stable, continuing to maintain the possibility of three rate cuts within 2025, with the first expected to occur in July. The three major U.S. stock indices closed higher; U.S. Treasury yields declined, with the 10-year yield down 2.52 basis points to 4.267%, and the 2-year yield down 1.24 basis points to 3.770%; the U.S. dollar index rose to 99.9006. The market did not have high expectations for the meeting but was pleased to see that the Federal Reserve did not make a more hawkish assessment after the tariffs were implemented. However, it should be noted that if the Federal Reserve relies on hard data, the expectation for the first rate cut in July may still be overly optimistic.

In terms of assets, the Federal Reserve seems unable to provide support through monetary easing in the short term, and the timing of rate cuts in the second half of the year remains uncertain. We might consider two potential changes in monetary policy under the condition that tariffs have not significantly decreased: (1) The Federal Reserve adheres to the current data-dependent principle and waits for economic deterioration before cutting rates at the end of the year; (2) The Federal Reserve gradually leans towards Waller's viewpoint, cutting rates early while ignoring inflation to protect economic growth.

In the first scenario, equity assets may experience a decline again as profit expectations decrease, until the economy deteriorates enough for the Federal Reserve to begin rapid rate cuts and the Trump administration's tax reduction expansion policy is substantively implemented; long-term U.S. Treasury yields may fluctuate lower as economic expectations decline, and once rapid rate cuts begin, they may weaken further, stabilizing below 4%; the U.S. dollar index may maintain a similar rhythm to U.S. Treasury yields, continuing to weaken.

In the second scenario, the Federal Reserve may consider moderate rate cuts as early as the beginning of the second half of the year, with equity assets observing economic trends more in a fluctuating manner. If rate cuts can alleviate the economic impact of tariffs and tax reductions are implemented, equity assets may reopen upward; in terms of long-term U.S. Treasury yields, they may initially weaken following rate cuts, then rebound again under the pressure of improved total demand and fiscal expansion, stabilizing around 4%; however, unlike U.S. Treasury yields, the U.S. dollar index may still weaken under the long-term reform framework of the Trump administration, but the degree of weakening will be less than in the first scenario.

Currently, the probability of the first scenario occurring is higher, meaning the Federal Reserve may still initiate rate cuts in the second half of the year, but the probability of the first rate cut occurring in July is weakening. This is partly due to the slow progress of tariff negotiations and partly due to the continuation of inertia in U.S. economic growth, coupled with private sector inventories buffering inflation increases and labor market downturns. The Federal Reserve may not have sufficient data in July to determine whether it should cut rates. However, it is still believed that the inflation center in 2025 will not be significantly higher than the range of 3.0%-3.5%, nor will it affect the long-term inflation center, so monetary policy will not remain persistently tight, and the Federal Reserve can still cut rates by 50-75 basis points within the year. **

Risk Warning

1. The risk of the U.S. labor market and economic data unexpectedly declining; 2. The risk of unexpected liquidity issues in the U.S. banking system; 3. The risk of Trump's policies unexpectedly stimulating inflation