CICC: How many more rate cuts can the Federal Reserve make?

According to the Zhitong Finance APP, CICC released a research report stating that at the September FOMC meeting, which concluded early this morning Beijing time, the Federal Reserve lowered the benchmark interest rate by 25 basis points to 4-4.25%. This marks the first rate cut in nine months since December last year. Although the Fed has been more optimistic than the market regarding whether a rate cut could be initiated, and this has been confirmed over the past two months, the magnitude of the current rate cut cycle is not aggressive. In addition to the unresolved inflation concerns, a slight rate cut can address most of the current growth pressures in the U.S., thus not requiring a significant reduction.

Considering that this meeting was quite standard, the future path of rate cuts did not exceed expectations and even showed some divergence. Given that the market and various assets have already priced in a considerable amount of rate cut expectations, it is anticipated that the "easing trade," which has lasted nearly a month, may pause for a while (lower rates, weaker dollar, rising gold, growth and emerging markets leading). The response from the U.S. stock market and major assets last night reflected this as well.

CICC's main points are as follows:

At the September FOMC meeting, which concluded early this morning Beijing time, the Federal Reserve lowered the benchmark interest rate by 25 basis points to 4-4.25%, marking the first rate cut in nine months since December last year. Following Powell's unexpected "dovish" stance at Jackson Hole, two months of disappointing non-farm payrolls, and a moderate rise in the August CPI, this rate cut has become a strong consensus in the market, and the "easing trade" has been in play for nearly a month. Therefore, aside from the rate cut, the focus of this meeting was on the subsequent pace of rate cuts and the internal divergences within the Federal Reserve following the appointment of new board members.

Chart: Implied probability of a rate cut before the meeting was 100%

Source: CME, CICC Research Department

Chart: After the meeting, the implied probability of a rate cut in October rose to 88%

Source: CME, CICC Research Department

In terms of results, this meeting can be considered "standard," reflected in: 1) a 25 basis point rate cut; 2) Powell described this rate cut as a "risk control" cut; 3) while mentioning the need to pay attention to the cooling job market, he still expressed concerns about ongoing inflation transmission; 4) regarding the future path of rate cuts, the "dot plot" expects two rate cuts within the year (but there is significant internal divergence, remaining in a state of uncertainty), which aligns with expectations.

Therefore, the market's reaction after the meeting was also mixed and a "realization of good news," with no shocks or surprises. U.S. Treasury yields and the dollar rose, gold fell, the Nasdaq slightly corrected, and the Dow Jones increased Chart: U.S. Treasury yields rise 10 years after the meeting, the dollar briefly falls before closing up, U.S. stocks and gold slightly retreat

Source: Bloomberg, CICC Research Department

Core message of this meeting: "Risk management" rate cut is moderate, "dot plot" expects two more rate cuts this year, but there are significant divergences

The rate was cut by 25 basis points to 4-4.25%, a "risk management" rate cut, primarily balancing risks. Powell's remarks this time are largely consistent with his statements at the August Jackson Hole meeting, portraying this rate cut as a "risk management" cut: on one hand, acknowledging the weakening labor market and adding the phrase "downside risks to employment have risen"; on the other hand, still highlighting inflation risks, with the wording "has moved up," while also mentioning in the press conference that he believes the transmission of tariffs to inflation will continue into next year, although the transmission speed to consumers is much slower than expected. Overall, the message from this meeting is that the balance between employment and inflation is indeed tilting towards employment, but it is not one-sided.

The "dot plot" shows two more rate cuts this year and one in 2026, but there are significant divergences. The changes in the voting committee have increased market attention to the "dot plot" and the independence of the Federal Reserve. Stephen Miran, an economic advisor to Trump, officially joined the Federal Reserve as a governor on September 15, and the dismissal of Lisa Cook was temporarily blocked by a federal court, thus both participated in this meeting's voting. For the 25 basis point rate cut in September, only Miran voted against it, alleviating market concerns about the independence of the Federal Reserve. However, there are clear divergences in the future rate cut path: 1) On the surface, the "dot plot" expects two more rate cuts this year, but looking closely at the voting distribution of the 19 committee members, 9 expect one more rate cut this year or even fewer, 9 expect two more rate cuts, and another person expects a 125 basis point cut (which is obviously unlikely, and the market speculates it might be Miran). In other words, if it weren't for Miran's low expectation pulling down the average, the "dot plot," which uses the median as the final result, is essentially evenly matched between one more rate cut or two this year, aligning closely with the current futures market's pricing of over 80% probability for rate cuts in October and December. 2) The divergences for 2026 are even greater, with the median only showing one rate cut, significantly less than the current futures market's pricing of three more cuts, but because next year involves Powell and several committee members' replacements, the market has not overreacted to next year's path.

Chart: The September FOMC "dot plot" shows two more rate cuts within 2025

Source: Federal Reserve, CICC Research Department

Slight adjustment of economic forecasts, not worried about growth and inflation pressures in 2026. This FOMC made little adjustment to economic data, slightly raising the growth forecasts for 2025 and 2026, slightly lowering the unemployment rate forecast for 2026, and raising the inflation forecast for 2026, indicating that the Federal Reserve is not concerned about growth and inflation pressures in 2026.

Chart: September FOMC economic forecasts raised the real GDP growth rate for 2025, while unemployment and inflation forecasts remain consistent with June.

Source: Federal Reserve, CICC Research Department

How much more can rates be cut in the future? "Preventive" rate cuts do not require much, the cycle is relatively short; the independence of the Federal Reserve next year is key.

Whether it is "preventive" rate cuts or "risk control" rate cuts, both imply that the Federal Reserve is temporarily unwilling to commit and does not believe that continuous and numerous rate cuts are necessary.

Chart: Rate cut cycles are divided into recessionary rate cuts and preventive rate cuts.

Source: CICC Research Department

Although previously more optimistic than the market about whether rate cuts could begin, the past two months have confirmed this, the required magnitude for this round of rate cut cycle is not aggressive. Besides the unresolved inflation concerns that the market is worried about, a slight rate cut can address most of the current growth pressures in the U.S., so there is naturally no need for too many rate cuts.

1. The current economic situation is not very bad, but rather differentiated, and rate cuts are expected to boost traditional demand. The degree of growth weakness determines the magnitude of rate cuts, but the current U.S. economy is not bad. The retail data for August, released before the meeting, showed a month-on-month increase of 0.6%, marking the third consecutive month of growth, further proving that the current growth in the U.S. is merely slowing due to structural differentiation, and it is still far from economic recession. Compared to the consistently strong AI investment, the internal differentiation of the U.S. economy is reflected in the traditional manufacturing and real estate sectors, which are continuously troubled by high interest rates. These two sectors are expected to gradually recover after rate cuts, combined with fiscal stimulus in the new year and already strong AI investment, which is expected to drive the recovery of the U.S. economy.

2. Inflation is still rising, albeit slowly. Unlike the previous "preventive" rate cuts, current inflation is still in an upward channel due to tariff impacts, and the transmission of tariffs to consumers is ongoing. The inflation data for August shows that the proportion of tariffs borne by consumers has slightly increased from 8-10% in April-July to around 12% At the same time, the inflation tail risk in the fourth quarter will also compress the space for interest rate cuts after the fundamental recovery. It is estimated that the year-end CPI year-on-year will reach 3.2% and then gradually decline, while the core CPI year-on-year will reach 3.4% at the end of the year, with a slowing slope.

Chart: Expected year-end CPI year-on-year at 3.2%, gradually peaking and declining; core CPI year-on-year at 3.4%

Source: Haver, CICC Research Department

Chart: August inflation data shows that the proportion of tariffs borne by consumers has risen from 8-10% in April-July to around 12%

Source: Haver, CICC Research Department

Under "natural conditions," the theoretical space required for this round of Federal Reserve interest rate cuts is 100 basis points, consistent with the current "dot plot," corresponding to long-term U.S. Treasury yields of 3.9-4.1%. The current difference between U.S. real interest rates and natural rates is 0.9%. A reduction of four times by 25 basis points to 3.25%-3.5% would achieve a "break-even" for financing costs and investment returns, corresponding to a nominal neutral rate of 3.6%. Assuming a term premium of 30-50 basis points, this corresponds to a 10-year U.S. Treasury yield of 3.9-4.1%.

However, the biggest variable is the independence of the Federal Reserve next year, which is also the reason why the market has not reacted much to the 2026 "dot plot." If Trump further interferes with FOMC decisions through personnel appointments, there is a certain probability that the Federal Reserve, which should not cut rates multiple times, will increase the pace of rate cuts, bringing risks of "overheating" in assets and the economy. This "dot plot" also reflects an increase in divergence.

Asset Implications? From "easing trade" to "recovery trade"; U.S. Treasuries and gold strong first then weak, dollar weak first then strong; U.S. stocks buy on dips, chasing technology in a pro-cyclical manner; Chinese market focuses on fundamental structure and U.S.-China mapping opportunities.

Considering that this meeting was quite standard, the future path of interest rate cuts did not exceed expectations and even showed divergence. Given that the current market and various assets have already factored in a considerable amount of rate cut expectations, it is expected that the "easing trade," which has lasted nearly a month, may pause for a while (interest rates down, dollar weak, gold up, growth and emerging lead). The response of the U.S. stock market and major assets last night was also in line with this.

From the perspective of various assets factoring in future rate cut expectations for the next year, interest rate futures (5 times) > Federal Reserve dot plot (2.9 times) > copper (2 times) > U.S. Treasuries (1.8 times) ≈ gold (1.8 times) > S&P 500 (1.4 times) > Dow Jones (1.2 times) > Nasdaq (1.1 times), which means that long-term rates, copper, and gold have factored in a considerable amount of rate cut expectations, while U.S. stocks have factored in relatively fewer rate cut expectations Chart: The current ranking of interest rate cut expectations for various asset classes is as follows: interest rate futures (5 times) > Federal Reserve dot plot (2.9 times) > copper (2 times) > U.S. Treasuries (1.8 times) ≈ gold (1.8 times) > S&P 500 (1.4 times) > Dow Jones (1.2 times) > Nasdaq (1.1 times)

Source: Bloomberg, CICC Research Department

Next, the market needs to observe: 1) Whether the non-farm and inflation data in September strengthen or weaken the probabilities for October and even next year; 2) Whether interest rate-sensitive growth data such as real estate sales and manufacturing PMI can improve in the next one to two months. If so, the "recovery trade" may gradually become dominant (interest rates and the dollar stabilize or even rebound, gold corrects, and emerging markets may differentiate due to their respective fundamentals). Under "preventive" interest rate cuts, there is generally a switch from "easing trade" to "recovery trade" within 1-3 months.

U.S. Treasuries: Short-term expectations are fully priced in, with a central range of 3.9-4.1%, initially strong then weak, initially long then short. Given that the current easing expectations priced into long bonds are relatively sufficient, the Federal Reserve's interest rate cuts may not necessarily lead to a sustained and significant decline in long-term rates. For instance, when the rate cuts began in September 2024 and during the initial rate cuts in 2019, U.S. Treasury rates bottomed out, and subsequently, rates continued to rise during the rate cut period. It is estimated that this round of four rate cuts corresponds to a 10-year U.S. Treasury rate central range of 3.9-4.1%, with a short-term hold until the rate cut expectations are fully priced in and the effects are realized, shifting from long-end to short-end.

Chart: 10-year U.S. Treasury rate central range of 3.9-4.1%, with highs presenting reallocation opportunities

Source: Bloomberg, CICC Research Department

U.S. Stocks: In an optimistic scenario, the S&P 6700, with pullbacks providing better entry opportunities; structurally, pro-cyclical and technology sectors are dominant. Previously, the target for U.S. stocks was clearly raised to a baseline scenario of 6200-6400, with an optimistic scenario of 6700, and the market is currently moving towards the optimistic target. Looking ahead, the Federal Reserve's interest rate cuts, improvements in the fiscal pulse for the new fiscal year in October, or the restoration of the credit cycle, combined with recent upward revisions in earnings expectations, remain favorable for U.S. stocks. If there are pullbacks, they may provide better buying points. Structurally, it is recommended to focus on technology (initial liquidity boost + continued acceleration in AI capital expenditure) and pro-cyclical sectors (which may gradually catch up after rate cuts).

Chart: In the baseline scenario, the S&P central range is 6200-6400, optimistic at 6700, with pullbacks providing better buying points

Source: FactSet, CICC Research Department

US Dollar: Weak first, then strong, expected to rebound slightly after improvement in fundamentals. Historically, the US dollar has strengthened after rounds of "preventive" interest rate cuts. If this round of cuts can quickly drive demand improvement and fundamental recovery, there is also a basis for a slight strengthening of the dollar. The dollar liquidity model indicates that the dollar will continue to fluctuate in the short term, with a slight recovery expected by the end of the year.

Chart: The dollar liquidity model shows fluctuations in the dollar in the second half of the year, with a recovery expected in the fourth quarter.

Source: Bloomberg, CICC Research Department

Gold: Asymmetric risks in both directions, suitable for holding; there is a risk of short-term pullback and switching to copper after interest rate cuts are realized. The three-factor model of the dollar, real interest rates, and uncertainty indicates that if uncertainty remains at the average level since the Russia-Ukraine conflict, the current reasonable gold price level corresponding to the dollar (98) and real interest rates (1.7%) is around $3,400 to $3,600 per ounce. The long-term trend for gold remains valid, but short-term gains may mainly occur before the interest rate cuts, with a certain pullback risk one month after the cuts.

Chart: The current reasonable gold price center corresponding to the dollar (98) and real interest rates (1.7%) is about $3,400 to $3,600 per ounce.

Source: Bloomberg, CICC Research Department

Chinese Market: Short-term boost from liquidity, small-cap and growth may outperform; if domestic policies do not reinforce this performance, more attention should be paid to the structure supported by fundamentals and the US-China mapping opportunities. In the current optimistic sentiment, attention can be focused on: 1) US-China mapping chains, such as computing power, robotics, and the fruit supply chain in technology, as well as tools for home decoration, furniture, and appliances related to the US real estate chain after interest rate cuts, and machinery and non-ferrous metals related to investment; 2) Sectors with improving fundamental prosperity, such as the internet, technology hardware, consumer electronics, innovative drugs, non-ferrous metals, and non-bank financials.

Chart: For the Chinese market, interest rate cuts are not a decisive factor; domestic fundamentals have a greater impact.

Source: Wind, CICC Research Department Chart: After the Federal Reserve's interest rate cuts in 2024, sectors related to the US real estate chain and non-ferrous metals related to investment will benefit.

Source: Bloomberg, Wind, CICC Research Department