Is the market too optimistic about interest rate cuts?

Is it really as Trump said: Can interest rate cuts become America's lifeline? We believe not necessarily, as this overestimates the Federal Reserve's ability to solve the current problems in the U.S. (government debt and stagflation environment).

Recently, expectations for interest rate cuts have begun to ferment. According to CME's FedWatch Tools (as of July 2, 2025), the market expects three rate cuts within the year and five by the end of 2026. The market is starting to show "muscle memory," with the U.S. dollar and U.S. Treasury yields declining in tandem, and U.S. stocks beginning to see valuation increases (the U.S. stock mid-term reports have not yet started, and profit changes are currently unclear).

Common sense suggests that interest rate cuts are good for both stocks and bonds, but here we may need to pour some cold water on the market:

First, interest rate cuts may not be so smooth.

The pace of the Fed's interest rate cuts may be more convoluted than the market's expected linear path. We believe that the Fed's rate cut pace may not be linear, as the market has not fully priced in the inflationary impact of a depreciating dollar. For example, in 2024, the U.S. imports approximately $3.3 trillion, with a trade deficit exceeding $1.2 trillion. If the dollar depreciates by 10%, the former will expand to about $3.6 trillion, while the latter, constrained by supply rather than demand, is unlikely to increase exports through thin profit margins. This will raise inflation while increasing downward pressure on the economy, putting the Fed in a dilemma.

The impact of tariffs on inflation will take time to manifest. In our report "How to Understand the Divergence of the Dollar and U.S. Stock Trends," we mentioned that in the second half of the year, with tax cuts and easing (expectations), the marginally greater impact will undoubtedly be "inflation." On one hand, if the dollar continues to weaken, imported inflation will still be a major issue. On the other hand, Trump's oil price decline policy is being interfered with by geopolitical factors, and the impact of tariffs on inflation is likely to be "not that it won't happen, but the time has not yet come."

Historical experience shows (see Figure 2) that when the dollar falls, imported inflation often pushes up prices, and there may also be a certain lag effect. In this round, although as of May, CPI data shows that U.S. prices have not yet shown a significant rebound. This is because Americans had a lot of time to stock up, from the confirmation of Trump's election in November to the implementation of tariffs in April, a full five months. During this time, the supply chain was racing against time to accumulate inventory, and please note that this inventory was accumulated when the dollar was high in value and without tariffs However, with the consumption of these inventories, the prices faced during subsequent replenishment will be high due to the dual impact of the depreciation of the US dollar and tariffs.

As the US dollar continues to weaken and the lagging effects of tariffs become apparent, a rebound in inflation is highly likely: we expect the service sector to maintain a relatively stable trend, but under the influence of a low base and tariffs, the rise in commodity prices will be a significant issue. Therefore, the year-on-year low point of the US CPI may have already occurred in April or May, and it will enter an upward phase thereafter. If the monthly average year-on-year growth rate of CPI in the second half of the year remains around 0.3%, then by the end of the year, inflation year-on-year will rise to around 4%.

Second, this interest rate cut may not be as effective.

The stimulating effect of this interest rate cut on demand may fall short of market expectations:

Firstly, the example of the Eurozone has already proven that in the context of global turmoil, interest rate cuts may not be effective. Due to structural constraints in the economy and external environmental pressures, the growth momentum of the European economy is slow. In the absence of coordination with other measures such as fiscal policy, the decrease in financing costs brought about by interest rate cuts is difficult to translate into actual demand expansion, especially when the starting point for interest rate cuts is too high. Therefore, although the Eurozone has cumulatively cut interest rates by over 200 basis points since 2024, both the recovery of manufacturing PMI and GDP have been relatively slow.

Secondly, the wealth effect of this interest rate cut may be different. The impact of interest rate cuts on economic entities should be analyzed from both the asset and liability sides (that is, both borrowers and lenders). The traditional argument for the benefits of interest rate cuts mainly focuses on the borrower side, neglecting the lender side (the holders of US Treasury bonds since the 1990s have mainly been either foreigners or the Federal Reserve, which indeed does not fall within the statistical scope of the US economy). One of the biggest structural changes in the supply and demand of US Treasury bonds in the past five years is that the US private sector holds an increasing amount of US Treasury bonds, especially short-term bonds. In this situation, interest rate cuts will affect both assets and liabilities: this interest rate cut may have a stronger adverse impact on the wealth effect (asset side) for the private sector. Although financing costs decrease, the overall stimulating effect of the interest rate cut may be less than before.

In fact, there may be cases where the cut is not sufficient, making it worse than not cutting at all. The current policy interest rate level of the Federal Reserve is relatively high, and we have repeatedly emphasized in previous reports that the pressure of maturity/refinancing of US corporate bonds will increase over the next two years. If replacing low-interest loans/bonds issued in 2020 that are maturing soon, if the interest rate cut is not substantial, the net financial cost may actually increase rather than decrease Therefore, we believe that expectations for interest rate cuts need to be cautious. Once the expectations are corrected (with summer inflation being a key focus), the market's reverse momentum could be quite strong (with the US dollar and US Treasury yields rebounding, while US stocks correct). After all, by late June, there was already significant betting on interest rate cuts for US dollar assets.

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