From December twenty-third, two thousand twenty-four to December twenty-fifth, two thousand twenty-four

I. Foundation 

resistance to change and hence greater dependability for the results shown in the past.

Three major patterns in soft-landing rate-cut cycles

When analyzing central bank behavior, focusing on marginal changes in unemployment data and the extent to which the policy rate deviates from neutral provides clearer policy signals, especially when the cycle is nearing its end or amid slowing economic growth.

G10 Central banks’ rate-cutting behavior during historical soft landings can provide a key reference for soft-landing rate-cut cycles.

First, policy in the early phase of a rate-cutting cycle is usually front-loaded (concentrated upfront), with a more cautious pace thereafter.On average, 50% of the rate cuts are completed within six months of the first cut (80% within one year). The pace of rate cuts gradually slows from 1.1 pp over the first 3 months to 0.7 pp over the final 3 months.

Additionally, A pause lasting at least three months occurs in as many as 70% of rate-cutting cycles, and nearly half of the cycles include at least two pauses.This indicates, Soft-landing rate-cut cycles are often long (50% of cycles last more than one year) and follow a “fast at first, then slow” pace, with central banks tending to make cautious, incremental adjustments as they approach the terminal rate.

Second, rising unemployment and a policy rate elevated relative to the neutral rate are important factors affecting the continuation of a rate-cutting cycle.Since rate cuts began, each 1 pp increase in the unemployment rate raises the probability of continued rate cuts by 40 pp, while each 1 pp overshoot in the policy rate increases the likelihood of continued rate cuts by 25 pp. By contrast, Changes in core inflation and GDP growth have a significantly weaker influence on rate-cut decisions.

Third, In historical soft-landing cases, central banks typically cut policy rates below neutral.At the end of the rate-cutting cycle, on average, the policy rate is 1 percentage points below the neutral rate, with the distribution skewed to the downside. Further regression analysis shows that rising unemployment is the main driver of central banks cutting rates below neutral.

Specifically, each 1-percentage-point increase in the unemployment rate raises the probability of cutting rates below neutral by more than 20 percentage points, while GDP growth and inflation have limited predictive power in determining whether the rate-cutting cycle ends at a restrictive or accommodative level.

Overall, Rising unemployment is the strongest predictor of continued or larger rate cuts.Regression analysis indicates that if unemployment rises, central banks are more likely to cut rates below neutral.

2024.12.24

II. Insights 

Our Viewpoints and ideas on market.

Discussing another possibility for last Wednesday

Technical indicators show that the US stock market has clearly entered oversold territory, laying the groundwork for a potential rebound. Historically, the probability of a year-end rally is about 76%, and market sentiment points to an optimistic outlook for year-end.

Some time has passed since the Fed’s remarks on Wednesday. They have indeed largely delivered on their commitments; what really spooked the market was the dot plot for the future released afterward.In hindsight, this market move may actually have had another possible explanation.

Before Wednesday, US equities had spent several consecutive months in an extremely unfavorable, highly concentrated trade. Although market performance appeared stable, as mentioned in notes some time ago, The US stock market is currently in a portfolio rebalancing period.

The past two weeks were the time when all domestic Mutual Funds rebalanced their portfolios and made their annual allocations., therefore, given that this negative market bias had already been in place, Wednesday's market may have needed only a nudge for sellers who needed to exit positions to start selling.

The reason for raising this possibility is that, looking back from today, Last week's selloff actually took place across all asset classes: assets with gains were sold, and all assets with losses were sold as well.。The key issue is this: if the market is really trading on the Fed's changed dot plot, with inflation expected to be more persistent, then Gold should not have plunged nearly 2.5% on Wednesday.

If the Fed was really saying that inflation was persistent and would rise, Wednesday should have been a big up day for gold. But that was not what happened: assets across the board moved in the same direction. In that case, it is more likely that rebalancing flows were using the news as a pretext.

Bonds were sold, stocks were sold, gold was sold, Bitcoin was sold—everything was sold.All profitable assets were sold to rebalance and distribute, while all losing assets were taken off the books.

It is reasonable to think and expect that many investment managers were actually waiting for the Fed's action on Wednesday at the time, The market needed only a reason to sell. Everybody was on one side of the boat, and I needed to clear the deck.

If that is how things play out, the market should continue to rally. Reallocation buying would provide a foundation for a year-end rally that lasts through the end of the year; historically, the year-end rally does tend to begin the day before Christmas.

2024.12.23

Sources of downside risk next year

So far, the market has interpreted every piece of bad news as good news because the Fed will cut rates.

During the rate-cutting cycle, this good-news trade will continue, because There will continue to be plenty of optimism, at least in the first half of the year, such as expectations of Federal Reserve rate cuts, more favorable tax policies under the new administration, and potential support for infrastructure, among other things.

The main issue is that if the economy slows more than expected next year (not a recession, just a slight slowdown),If the slowdown that is highly likely to occur in the economy next year actually happens, the micro-level earnings logic underpinning the U.S. stock market will no longer hold up.

Additionally, date X will most likely fall between months 7 and -9 next year; see:https://mp.weixin.qq.com/s/SXwaTPRwELUko7I8MyRW7A(if the U.S. abolishes the debt ceiling)

In fact, in economies around the world outside the United States—the eurozone, the United Kingdom, Asia, and Japan—growth rates are often close to recession levels. They are growing, but only barely. Meanwhile, U.S. economic growth is 3.2%, nearly crushing all the others. This is why U.S. stocks have attracted large inflows of capital.But this anomaly—the difference in economic growth between other countries and the United States—is unsustainable.

Either other countries will make a concerted push and begin accelerating growth to catch up with U.S. economic growth, or U.S. growth will slow to bring it in line with theirs (This is the more likely scenario), because the current mechanism of economic interaction in the United States is still to import deflation and export inflation. Over the coming year, the United States will import deflationary pressure from the global economy into the country, This also means that U.S. economic growth will inevitably slow unless there is another large-scale stimulus bill or another type of infrastructure spending bill.

See:

1) Notes 24-12-16 U.S. stocks move into late-cycle trading https://www.meridianresearch.app/notes/7ef1c4bf-4eb9-4bc2-af82-a8e2a9f9eabc?ref=769bd1d1-1bdb-461a-89c9-e42c1ff5beebView note

2) Notes 24-10-31 In the U.S. equity market, micro-level earnings matter more than macro factors:https://www.meridianresearch.app/notes/75a9cbf5-8715-4f56-8722-9ee9c33dc638?ref=769bd1d1-1bdb-461a-89c9-e42c1ff5beebView note

2024.12.23

Next year’s monetary easing is being underestimated

Expectations for monetary policy easing have cooled markedly. Fed funds futures currently price in less than 40bp in rate cuts for 2025, a sharp reduction from the 125bp expected after the 9 50bp rate cut.

Much of the adjustment is justified, but it has gone too far.

1) Market expectations for easing in 2025 have fallen sharply​

2) But the inflation rebound concern is actually overstated

3) Tariff risks are also overpriced; the price shock is most likely a one-off

From a monetary policy perspective, first, Unless they trigger significant second-round effects through wages or inflation expectations, the inflationary impact of the one-off increase in the price level caused by tariffs will disappear after about a year，making it comparable to the repeated VAT increases in other G10 economies, which typically leave no lasting mark on inflation or monetary policy.

Second, the trade war that took place in 2018-2019 The trade war tightened financial conditions, prompting the Fed to ease. This cycle has many differences, but past experience suggests that the monetary policy risks from tariffs are at least two-sided.The risks tariffs pose to monetary policy are at least two-sided.

4) It is too early to conclude that the labor market is stable

5) Europe’s recession may be deepening

In addition to slow productivity growth, high energy prices, and intensifying competition from the East, the risk of punitive U.S. tariffs is also looming. Trade policy uncertainty has surged since the U.S. election, while manufacturing indicators have fallen further, which could increase the likelihood of a deeper industrial recession in the euro area.​

6）Cushion the Hit from Higher US Tariffs？

Overall, the US-Europe divergence is largely priced in, equities and credit are likely to continue delivering positive returns, but given current high valuations, low hedging costs, and the risk of a seasonal downdraft around the New Year, hedges could be increased modestly Hedge allocations can be increased modestly.

The real trade-weighted dollar is currently at its strongest level of the floating exchange rate era, second only to the pre-Plaza Accord peak in 1985. Despite the Fed’s hawkish repricing continuing to play out, the EM rates market remains relatively resilient, and long opportunities in Central and Eastern Europe may be worth watching.

We continue to expect oil and natural gas to trade in ranges, with divergent trends across metals (iron ore could fall further), while copper and gold Gold may perform more strongly.

2024.12.24

III. Market Pulse 

Our latest Comments on the economic and market environment

Leveraged Loan Default Spike

The default rate on junk loans in the US market is rising at the fastest pace in four years, reflecting the full emergence of the aftereffects of the post-pandemic wave of low-cost borrowing. According to Moody’s data, over the 12 months through 10, the default rate in the global leveraged loan market (primarily the U.S.) rose to 7.2%, its highest level since the end of 2020.

Compared with high-yield bonds, the default rate on junk loans is rising faster,Riskier companies are more inclined to use floating-rate leveraged loans.The excess debt issuance during the pandemic-era low-rate environment is now facing a severe test from high borrowing costs. Although the Fed has begun cutting rates, the market impact of borrowing-cost pressures cannot be ignored.

This trend could continue through 2025. On the one hand, high borrowing costs continue to penalize companies; on the other, lender protections have weakened further as covenant-lite structures have become more common. Moody’s notes that in 2024, many lower-rated companies were unable to raise financing in public or private markets and had to restructure their debt, causing the default rate in the leveraged loan market to far exceed that in the high-yield bond market.

More concerning, distressed exchanges They have accounted for more than half of this year’s default events, the highest proportion ever.Although this type of transaction avoids direct bankruptcy, it effectively reduces lender recoveries. Many asset-light companies (such as those in healthcare and software) may have even lower recovery rates in default because they lack sufficient asset backing.

Even so, the high-yield bond market spread remains at its lowest historical level since 2007, showing that investors’ appetite for yield remains strong; this “exuberance” may be disconnected from actual market risks.

In the short term, as the Fed’s rate-cutting cycle progresses, borrowing costs may ease somewhat, giving companies some breathing room, and default rates in both the high-yield bond and leveraged loan markets may stabilize. But Ruth Yang of S&P Global believes that looser Loan terms merely postpone the problem; they do not solve it fundamentally。

2024.12.25

Note: All content herein is for reference only, does not constitute investment advice, and is not a basis for any laws, regulations, or regulatory policies. Investors should not use or rely on this information as a basis for making decisions.