Hao Zhou is the Chief Economist of Guotai Junan International and a member of the China Chief Economist Forum
Due to the outstanding performance of the U.S. economy and inflation, the market has been pushing back the Fed's interest rate cuts. At the same time, the market also expects the Fed to reduce the number of interest rate cuts in the dot plot at the June interest rate meeting, most likely from 3 in March to 2.
However, the actual trend of the 10-year Treasury rate has been relatively stable, although it quickly broke above 4.5% at the end of March and briefly moved towards 4.7%, but has since been on the decline, broadly stabilizing below 4.5% over the past few sessions. The previous poor performance of a number of employment data seems to have been the core factor in the relatively modest performance of interest rates.
Looking at the supply situation in the bond market, there are also several factors worth paying attention to. First, the U.S. fiscal deficit in fiscal year 2024 is likely to be lower than previously expected due to the good performance of the economy and a better-than-expected tax situation. At the same time, the Fed announced that it would slow its balance sheet reduction starting in June, reducing the size of its balance sheet by $35 billion per month compared to the previous month. Combined, this means that the net supply to the Treasury market will be reduced by about $300 billion in the second half of this year.
As the market has sharply lowered its interest rate cut expectations for this year, from a gaming perspective, even if the economic and inflation data exceed expectations, there is a high probability that the strength of interest rate increases will be limited; On the contrary, once the economy and inflation cool, the trade of interest rate cuts is more likely to become the theme of the market.
In these respects, the 10-year Treasury rate has most likely found the top area for the year; Of course, once the rate cut trade prevails, the 10-year Treasury rate may also find a bottom. In other words, the market is starting to price in the new normal of the U.S. economy, and for equity investors, the impact on the stock market will gradually decrease as the marginal surprise from U.S. Treasuries becomes smaller and smaller. Due to the outstanding performance of the U.S. economy and inflation, the market has been pushing back the Fed's interest rate cuts. At the same time, the market also expects the Fed to reduce the number of interest rate cuts in the dot plot at the June interest rate meeting, most likely from 3 in March to 2.
However, the actual trend of the 10-year Treasury rate has been relatively stable, although it quickly broke above 4.5% at the end of March and briefly moved towards 4.7%, but has since been on the decline, broadly stabilizing below 4.5% over the past few sessions. The main factors that triggered the decline in US Treasury interest rates were the non-farm payrolls data for April, which came in sharply lower than expected, while the initial claims for unemployment benefits released this week were also significantly higher than expected. After the May meeting, Fed Chairman Jerome Powell expressed his views on the trigger conditions for a rate cut – either inflation falling more than expected, or a big problem in the job market, or both. April inflation data is not due until next week, but a number of poor employment data have appeared to be the core factor in the relatively modest performance of interest rates.
At the same time, there are several factors to watch from the perspective of the supply situation in the bond market. First, the U.S. fiscal deficit in fiscal year 2024 is likely to be lower than previously expected due to the good performance of the economy and a better-than-expected tax situation. The market's new view is that the fiscal deficit in 2024 will be about $1.65 trillion, lower than the previous expectation of about $180 million. At the same time, the Fed announced that it would slow its balance sheet reduction starting in June, reducing the size of its balance sheet by $35 billion per month compared to the previous month. Combined, this means that the net supply to the Treasury market will be reduced by about $300 billion in the second half of this year. Coupled with a higher-than-expected surplus in the US Treasury's TGA account, the bond market overall is in a better-than-expected supply situation. Judging from the recent auction of treasury bonds, the overall winning situation is also relatively ideal.
As the market has sharply lowered its interest rate cut expectations for this year, from a gaming perspective, even if the economic and inflation data exceed expectations, there is a high probability that the strength of interest rate increases will be limited; On the contrary, once the economy and inflation cool, the trade of interest rate cuts is more likely to become the theme of the market. From the perspective of GDPNow and the 10-year Treasury note, the correlation between the two is relatively high, and the recent trend of the two is basically the same, which to a certain extent indicates that economic fundamentals are still the most important determinant of interest rates. For now, GDPNow expects the U.S. economy to grow by more than 4% in the second quarter (annualized quarter-on-quarter), which is significantly higher than the 1.6% growth rate in the first quarter, but to some extent implies that the probability of the economy going up in the future is low (considering that the potential growth rate of the U.S. economy is likely to be no more than 2%).
Judging from the feedback of other markets on U.S. bonds, one of the more obvious changes is that when the 10-year U.S. bond interest rate quickly exceeds 4.5%, U.S. stocks have adjusted to a certain extent. But the stock market soon rebounded due to the generally modest performance of interest rates. From this perspective, the "seesaw" effect between the stock market and bond yields seems to be more pronounced only during periods of rapid interest rate increases, and most of the time equity investors do not pay much attention to macro factors.
On the other hand, the "desensitization" of equity investors to interest rates may mean that the market is beginning to accept a higher dollar interest rate pivot, and the fundamental driving force behind this is still the medium-term trend of the US economy and inflation. While the so-called "new normal" and "new hub" are a posteriori conclusion, financial markets seem to have reached a certain consensus and agree that as long as inflation does not stall, a relatively higher interest rate environment will not be a boggling for investment. At the same time, the Federal Reserve and the Treasury also play a role in coordinating the market mechanism, the Fed slows down the reduction of its balance sheet, and the Treasury Department announces the buyback plan, both of which technically ensure that the trend of interest rates remains roughly stable.
In these respects, the 10-year Treasury rate has most likely found the top area for the year; Of course, once the rate cut trade prevails, the 10-year Treasury rate may also find a bottom. In other words, the market is starting to price in the new normal of the U.S. economy, and for equity investors, the impact on the stock market will gradually decrease as the marginal surprise from U.S. Treasuries becomes smaller and smaller.