Minsheng Securities: Market interest rate cut expectations are "overheated," and the Federal Reserve may cool optimistic expectations

According to the Zhitong Finance APP, Minsheng Securities released a research report stating that a cautious attitude should be maintained regarding interest rate cut expectations. Although the possibility of the Federal Reserve continuously cutting interest rates from the fourth quarter to early next year cannot be ruled out (if there are clear upward signals such as rising unemployment rates), the current market bets on rate cuts seem somewhat overly aggressive, ignoring potential volatility risks. Even though there are still disagreements among Federal Reserve officials, market pricing shows a rare "consistent optimism."

This also means that once any reverse signals (such as rapid inflation increases and non-farm payroll corrections) emerge, leading to a correction in expectations, market volatility will be amplified again: U.S. Treasury yields may rebound, and U.S. stock sectors that are relatively sensitive to interest rate cuts (growth stocks and cyclical stocks) will be affected, while the rise of metals with strong financial attributes (gold, silver, copper) will slow down. Recently, Powell's statements have been quite significant—emphasizing that "interest rates remain moderately restrictive" and "stock valuations are high," which may intentionally cool down the overheated optimistic expectations.

The main points of Minsheng Securities are as follows:

The sharp decline in non-farm payrolls since July continues to affect the nerves of the Federal Reserve and the market. Although other core employment indicators such as unemployment rates and wages have not significantly deteriorated, there is no disagreement that the continuous weakness in new non-farm payrolls is the "culprit" forcing the Federal Reserve to reassess employment risks and implement a "risk control-oriented rate cut" in September.

However, we believe that the pace of rate cuts by the Federal Reserve may be more convoluted than the market's expected linear rate cut path. We have continuously pointed out in previous reports that potential inflation risks in the fourth quarter will become a "roadblock" to continuous easing policies.

In this report, we will focus on another key variable—employment, and whether there is a possibility of upward revision, which could inversely suppress the priced-in expectations of rate cuts.

The "noise" in this year's non-farm data has become increasingly prominent: The response rate to surveys has significantly declined, and layoffs by the Federal Reserve have affected data collection quality, leading to doubts about its accuracy. However, as the most core official indicator of the labor market, both the market and the Federal Reserve still have to rely on its fluctuations for pricing and decision-making.

On the other hand, the seasonal adjustment mechanism and model characteristics of non-farm payrolls have also amplified short-term data volatility. Since the Department of Labor incorporates newly released data into the seasonal adjustment model each month to generate new seasonal adjustment factors and retroactively revise the non-farm employment data for the past three months, July and August are often peak periods for seasonal fluctuations in the labor market. Once included in the model, the dynamic adjustment of seasonal adjustment factors may increase short-term disturbances in the data for the past three months, leading to consecutive large downward revisions in non-farm payrolls.

However, historical experience shows that the initial value of non-farm payrolls for August announced in September often undergoes seasonal revisions in October. Looking at the data from the past 20 years (2005-2024), the probability of upward revisions for August non-farm payrolls in the two revisions in October exceeds 80%, the highest for any month, while the final value announced in November also has a probability of upward revision of around 70%.

The overall upward revision magnitude should not be underestimated, as both the median and average values for the subsequent upward revisions of August non-farm payrolls rank among the highest for the year. Given that there have already been signs of upward revisions in July's non-farm payrolls, combined with White House economic advisor Hassett's hint that "the employment report may be revised upward by nearly 70,000 jobs," the potential upward revision of August non-farm payrolls cannot be ignored in terms of its impact on interest rate cut expectations.

We believe the reasons for the seasonal upward revision of August non-farm payrolls may include:

On one hand, after the significant annual benchmark revision in September, the overall trend component of non-farm payrolls in the CES model has clearly shifted downward (the trend component can be understood as the reference frame for seasonally adjusted non-farm data, and a downward shift makes originally "weak" data appear relatively "strong"), thus leaving little room for downward adjustments in the two revision data for August non-farm payrolls announced in October;

On the other hand, since the unadjusted data for August non-farm payrolls often shows a significant seasonal increase, but the initial value announcement did not incorporate all survey responses (especially given the significant decline in current response rates), the subsequent recovered surveys may reflect a more optimistic employment tendency.

In comparison with other labor market indicators, there is also a probability of underestimation for August non-farm payrolls. Indicators such as ADP employment, PMI employment index, and small business hiring plans generally have a higher correlation with the final value of non-farm payrolls than with the initial value, and the current downward trend of these indicators for August is manageable, not showing the severe slowdown seen in the initial value of non-farm payrolls. This comparison also suggests that there is a certain probability of upward revision for August non-farm payrolls.

Therefore, the guidance of August non-farm payrolls on interest rate cut expectations may be disturbed, similar situations have occurred around the time of the Federal Reserve's first interest rate cut last year: The continuous downward revisions of non-farm payroll data and the rising unemployment rate in June-July last year triggered market recession fears, prompting the Federal Reserve to cut rates in September, with the market once pricing in another 50 basis point cut in November However, in October, the Labor Department significantly revised up the non-farm payroll data for July and August, leading to a cooling of the recession narrative and aggressive expectations of a 50 basis point rate cut.

In terms of assets, U.S. Treasury yields, especially at the short end (2-year), surged about 20 basis points on that day; the dollar rose, and prices of precious metals such as gold, silver, and copper saw a noticeable short-term correction; U.S. stocks experienced a slight short-term pullback but ultimately continued to rise under the retreat of the recession narrative and the support of moderate rate cuts. Of course, unlike last time, this round of asset pricing is more driven by bets on rate cut expectations, without the participation of the recession narrative, which also means that the upward revision of non-farm payrolls may have a greater negative impact on risk assets.

In summary, we need to continue to observe expectations for rate cuts. Although we do not rule out the possibility of the Federal Reserve continuously cutting rates from the fourth quarter to early next year (if there are clear upward signals such as rising unemployment rates), the current market bets on rate cuts seem somewhat overly aggressive, ignoring potential volatility risks. Even though there are still disagreements among Federal Reserve officials, market pricing shows a rare "consensus optimism."

This also means that once any reverse signals (such as rapid inflation increases and reverse corrections in non-farm payrolls) lead to adjustments in expectations, market volatility will be amplified again: U.S. Treasury yields may rebound, and U.S. stock sectors that are relatively sensitive to rate cuts (growth stocks and cyclical stocks) will be affected, while the rise of metals with strong financial attributes (gold, silver, copper) will slow down. Recently, Powell's statements have been quite significant—emphasizing that "rates remain moderately restrictive" and "stock valuations are high," which may be intended to cool down the overheated optimistic expectations.

Risk Warning: Significant changes in U.S. economic and trade policies; unexpected expansion of tariffs leading to greater-than-expected global economic slowdown and increased market adjustments