The expectation of a push for a Fed rate cut is still fermenting, and the number of rate cuts implied by CME interest rate futures has been reduced to one last year, that is, in September, causing the 10-year Treasury and the dollar to continue to rise, approaching the previous high. The S&P 500 index fell 3.1% last week, and the Nasdaq index fell 5.5%, causing market attention. On the one hand, the decline of US stocks has its "inevitability", and on the other hand, the fall of US stocks in this position is not a bad thing, not only to absorb its overly strong expectations, but also to help the interest rate cut trade to open again, and then lay the foundation for the subsequent rise again.
Why is the decline in US stocks not a bad thing? How can it actually prompt the Federal Reserve to resume interest rate cuts? When will it fall? How can it be predicted in advance? We analyze several issues of general concern to the market as follows.
summary
Why is there an "inevitability" for U.S. stocks to fall?
The inflection point of liquidity and interest rate cuts in the second quarter were postponed. 1) The inflection point of financial liquidity in the second quarter will put pressure on U.S. stocks. Recently, it has become clear that US financial liquidity has begun to weaken. 2) The moderate correction in U.S. stocks is the result of the postponement of current interest rate cut expectations. The surge in U.S. Treasury rates and the U.S. dollar has put pressure on U.S. stocks, especially growth stocks.
Why is it not a bad thing for U.S. stocks to fall?
A decline in U.S. stocks can lead to a tightening of financial conditions, which is a prerequisite for resuming the interest rate cut trade. Based on the weighting of the financial conditions index, if the financial conditions index regains from the current 99.6 to the October high of 100.7, it will require the U.S. stock market to pull back 8-10% to around 4700 points, and the U.S. credit spread will widen by about 50bp.
How will the follow-up evolve and how to lay out in advance?
The situation is likely to improve again after the third quarter. On the one hand, the Fed is expected to start reducing its balance sheet in June, which will help hedge against the current liquidity inflection point. On the other hand, the current tightening of financial conditions will be reflected in real growth pressures and inflation and growth surprises indices over the next 1 to 3 months. From the perspective of assets, if the next round of interest rate cut transactions is arranged, short-term bonds are better, long-term bonds are secondary, and U.S. stocks have a sufficient pullback.
body
Why is there an "inevitability" in the decline of US stocks? The inflection point of liquidity and interest rate cuts in the second quarter have been postponed
First, the inflection point in financial liquidity in the second quarter will put pressure on U.S. stocks. In our March 11 report, "U.S. Liquidity May Reach an Inflection Point", we suggested that U.S. financial liquidity will usher in an inflection point in the second quarter, which may lead to a reallocation of funds between stocks and bonds, which in turn will put pressure on U.S. stocks and assets. The difference between the size of the Fed's balance sheet (the progress of the Fed's balance sheet reduction) - the TGA account (changes in fiscal deposits) and the reverse repo (the Fed's reverse repo usage, mainly the funds deposited in the Fed's account by the cargo base) is used to measure the liquidity in the financial system, which is approximately equal to the size of the reserves in the commercial banking system. The recent change is that the Fed's monthly balance sheet reduction continues, but the US tax season in mid-April will recover a lot of money, and reverse repos, the largest contributor since the end of last year, are almost depleted ($795.6 billion today) (Chart 1). This is largely validated, and US financial liquidity has recently begun to weaken significantly (Chart 2).
Chart 1: Reverse Repos Are Almost Exhausted Right Now, Falling to $795.6 Billion
Source: Bloomberg, CICC Research
Chart 2: Financial liquidity has weakened significantly recently
Source: Bloomberg, CICC Research
Financial liquidity mainly exerts an impact on U.S. stocks and assets from a quantitative perspective, and we have found that this indicator has a good explanatory power for the medium-term trend of U.S. stocks since it was introduced in July last year ("U.S. Stocks Losing Liquidity "Help"). For example, after the Silicon Valley Bank problem erupted in March 2023, the Federal Reserve provided a one-year loan to the problem through BTFP, which drove a surge in liquidity, explaining the market rebound in the second quarter; after the debt ceiling issue was resolved in June 2023, the U.S. Treasury issued a large amount of bonds to replenish funds, explaining the decline in U.S. stocks and the sharp rise in U.S. bond interest rates in the third quarter; and since October, a large number of reverse repos have returned to the market to buy U.S. bonds from the Fed's books, explaining the decline in interest rates and the rise in U.S. stocks since the end of last year. Based on this, we also warned in early March that the inflection point of financial liquidity in the second quarter may put pressure on the market, and it has basically been verified so far.
Second, the moderate correction in U.S. stocks is the result of the postponement of the current interest rate cut expectations, and it is also a condition for the resumption of interest rate cuts. The recent postponement of interest rate cut expectations has caused Treasury rates and the US dollar to surge, which in itself will put pressure on US equities, especially growth stocks. Moreover, the source of the postponement of the expectation of this round of interest rate cuts is a direct result of the improvement in demand following the fall in interest rates and the easing of financial conditions in the fourth quarter of last year ("The Fed's Threshold for Rate Cuts" (Chart 3). Therefore, to achieve the goal of suppressing inflation, it is necessary to suppress demand, and to suppress demand, it will require a further tightening of financial conditions. In addition to being a component of financial conditions (Chart 4), the wealth effect of the rise in US equities has also boosted demand and prices, which is why US equities need a modest correction, otherwise this outcome will not be achieved.
Chart 3: Demand improved after lower interest rates and easing financial conditions in the fourth quarter of last year
Source: Haver, CICC Research
Chart 4: The Financial Conditions Index includes U.S. stocks
Source: Bloomberg, CICC Research
Why is it not a bad thing for U.S. stocks to fall? A decline in U.S. stocks can lead to a tightening of financial conditions, which is a prerequisite for resuming the interest rate cut trade
As we analyzed in "The Threshold of Fed Interest Rate Cuts", the recent good demand and high inflation in the United States are precisely the lagged results of the excessively rapid decline in interest rates in the fourth quarter of last year, so they can be suppressed by re-tightening financial conditions, so there is no need to go to the other extreme of thinking that interest rates cannot be cut at all, or even raise interest rates, just as the US Treasury interest rate was higher at 5% in October last year and lower at 3.8% at the beginning of this year.
However, there are two costs to this process: first, the relapse of time, fundamentals and interest rates will make the short-term window for interest rate cuts no longer exist, and second, the retightening of assets and financial conditions needs to be premised on a moderate decline in US stocks and credit bonds. The Financial Conditions Index is made up of long-end Treasuries, the U.S. dollar, U.S. equities, credit spreads, and benchmark interest rates (Chart 5). Both long-end Treasuries and the US dollar are now back at their highs, even approaching their October highs, but financial conditions remain low (currently at 99.6, down from 100.7 in October), with the main gap being in US equities and credit spreads (Charts 6-8).
Chart 5: Nominal Treasury rates have more than halved compared to October last year
Source: Bloomberg, CICC Research
Chart 6: The U.S. dollar index is trading near a previous high of 107, while financial conditions are widespread
Source: Bloomberg, CICC Research
Chart 7: Credit spreads and U.S. equity markets are the main reasons why financial conditions have not risen significantly
Source: Bloomberg, CICC Research
Chart 8: The Rapid Decline in Interest Rates After October Was Dominated by the Suppression of Demand by Higher Interest Rates, Leading to a Succession of Lower-than-Expected Key Economic Data
Source: Bloomberg, CICC Research
Based on the weighting of the financial conditions index, we can achieve this "task" if the financial conditions index reverts from the current 99.6 to the October high of 100.7 last year, the US stock market pulls back 8-10% to around 4,700 points, and the US credit spread widens by about 50bp (Chart 9). Think about it, if U.S. stocks remain high and do not pull back, and credit spreads do not widen, financial conditions will not be able to tighten effectively, which will only be compensated by higher long-term interest rates, which will cause more strength for these two types of assets. Commodities, while not directly a component of the financial conditions index, are logically similar.
Chart 9: A ~50bp widening in credit spreads and an 8-10% decline in US equities could lead to another tightening of financial conditions
Source: Bloomberg, CICC Research
How will it evolve in the future? How will it be laid out in advance? The situation may improve after the third quarter; short-term debt is better, long-term debt is secondary, and the correction of US stocks is sufficient
Statically, our two models of financial liquidity and financial conditions above point to the possibility that the situation may improve again after the third quarter. On the one hand, the Fed is expected to start reducing its balance sheet in June, which will help hedge against the current liquidity inflection point and make it improve again (How does the Fed end its balance sheet reduction?). On the other hand, based on historical experience, the current tightening of financial conditions will be reflected in real growth pressures and inflation and growth surprises indices over the next one to three months (Chart 10). In fact, with the recent rise in the US 30-year mortgage rate, existing home sales, which have been an important support for the recent good demand and high inflation in the US, have begun to retreat (Chart 11). At that time, the "turnaround run" after the correction of various assets, as well as the re-suppression of demand and prices, may lead to the resumption of interest rate cut trades, and assets may also have better opportunities, but we still remind against expecting too many and too fast rate cuts as at the beginning of the year.
Chart 10: Financial conditions have a lead over growth and inflation, and tighter financial conditions can ultimately suppress demand and inflation
Source: Bloomberg, CICC Research
Chart 11: Existing home sales weakened again in March after rising mortgage rates
Source: Haver, CICC Research
From an asset perspective, although it may take some time, we also need to think backwards at the right time. If the next round of interest rate cut transactions is arranged, 1) short-end treasury bonds are a better choice (the probability of another interest rate hike is smaller), 2) long-end treasury bonds are secondary, and you can wait appropriately (4.7% basically corresponds to no interest rate cut within the year, which is more sufficient, 5% last year The pressure on the issuance of Treasury bonds corresponding to the high point does not exist this year, so the term premium is basically zero, Figure 12);3) U.S. stocks and U.S. credit bonds are recommended to avoid short-term recommendations, and we estimate that the U.S. stock market around 4700 points and the U.S. credit bond spread can complete the task and intervene after the pullback;4) Commodities are also seriously rushed, although they are not directly reflected in the financial conditions index, but they promote the logic of commodity price rise and demand improvement, and like U.S. stocks and U.S. credit bonds, they need to retreat to promote the final realization of interest rate cuts。
Chart 12: Long-term bonds are under pressure to rise in the short term, and 4.5-4.7% basically corresponds to no rate hike
Source: CME group, CICC Research
At present, the biggest variable facing this static deduction is that large supply-side shocks (such as geopolitical escalation) will cause inflation to spiral out of control, making it impossible to achieve this goal by relying solely on the spontaneous and modest contraction of financial conditions, and will also increase the volatility of asset prices.
Article source:
This article is excerpted from: "The U.S. Stock Correction Helps the Resumption of Interest Rate Cut Trades April 15~21, 2024" that has been released on April 22, 2024
刘刚，CFA 分析员 SAC 执证编号：S0080512030003 SFC CE Ref：AVH867
Wang Zilin Contact SAC License No.: S0080123090053
Legal Notices