Shenwan Hongyuan: Financial pressure may be the main contradiction for the Federal Reserve to "turn dovish"

According to the Zhitong Finance APP, Shenwan Hongyuan has released a research report stating that there is significant divergence in market expectations for the Federal Reserve's interest rate cuts in the face of inflation risks that may be triggered by tariffs. The U.S. economy faces the risk of "stagflation turning into recession" under the impact of tariffs, and financial pressure may become a core variable for the Federal Reserve's policy shift. Currently, the manufacturing PMI continues to contract, and the debt risk in commercial real estate is accumulating, coupled with rising volatility in U.S. stocks, which may force the Fed to initiate interest rate cuts in the third quarter of 2025. The bank expects that if the financial pressure index breaks the threshold, the annual interest rate cut may reach 75-100 basis points, and it suggests paying attention to opportunities for U.S. Treasury yield declines and strategic allocation windows for the Nasdaq.

Shenwan Hongyuan's main points are as follows:

1. In a stagflation environment, how does the Federal Reserve balance its "dual mandate"? Financial pressure may be the main contradiction.

Under the impact of tariffs, stagflation is a "problem" for the Federal Reserve's decision-making. The economic effect of tariffs is "stagflation." Indicators such as manufacturing PMI and short-term inflation expectations have indicated that the risk of stagflation is approaching. The balance of the "dual mandate" leaves the Federal Reserve in a dilemma. The May FOMC meeting indicated that the Fed may choose a "reactive" stance rather than a "preventive" one.

In a stagflation environment, financial pressure may become the main contradiction for the Fed's "dovish shift": 1) The risk of inflation may exceed the pressure of stagnation; 2) Rising financial pressure may strengthen the risk of economic downturn and weaken the risk of inflation; 3) Overall, due to the "temporary" nature of inflation triggered by tariffs, the Fed may focus more on the risk of economic downturn after considering "risk balance."

2. Beyond the "dual mandate," how does financial pressure affect the Fed's "decision-making"? Intensifying economic pressure prompts the Fed to shift dovishly.

When financial pressure continues to rise significantly, the Fed may consider policy hedging. Financial pressure can comprehensively measure financing conditions, default risks, or risk preferences. On one hand, rising financial pressure inherently implies expectations of economic downturn; on the other hand, under the "financial accelerator" mechanism, rising financial pressure may further exacerbate economic downturn pressure, such as turning a slowdown into a recession.

Historically, rising financial pressure is an important condition for the Fed's "dovish shift." 1) In 2015-2016, facing global economic uncertainty, the Fed slowed down interest rate hikes; 2) The "hawkish" rate hike in September 2018 led to a nearly 20% pullback in U.S. stocks, prompting the Fed to "shift dovishly"; 3) In early 2020, under the impact of a public health event, the Fed quickly cut rates to 0 and initiated QE; 4) In August 2024, non-farm payrolls fell short of expectations, triggering a "recession warning," leading to a significant market correction. The Fed chose a preventive rate cut of 50 basis points in September.

3. In 2025, how to grasp the "rhythm" of the Fed's interest rate cuts? The first rate cut may land in the third quarter.

Under the impact of tariffs, the main line of the U.S. economy may gradually shift from "stagflation" to "recession." In the next 1-2 quarters, the market may be entangled in the issues of "stagnation" versus "inflation," and whether to slow down or enter recession. In the second half of this year, if the slope of price increases slows down while the economic downturn remains unchanged, the main contradictions in the economic fundamentals, major assets, and policies may gradually shift from "stagflation" to "recession." In 2025, a rate cut by the Federal Reserve is still expected, with the first cut possibly occurring in the third quarter. At the June meeting, if the financial markets operate smoothly, the probability of a rate cut may trend downward. However, looking towards the second half of the year, whether it is the "stagflation trade" or the "recession trade," financial pressures will still tend to rise, thereby paving the way for the Federal Reserve to cut rates.

Risk Warning

Escalation of geopolitical conflicts; U.S. economic slowdown exceeding expectations; Federal Reserve turning "hawkish" beyond expectations