December twenty-third, two thousand twenty-four to December twenty-fourth, two thousand twenty-four

I. Foundation 

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

Three main patterns in rate-cutting cycles during soft landings

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 a cycle is nearing its end or economic growth is slowing.

G10 central banks’ rate-cutting behavior during historical soft landings can provide key guidance for rate-cutting cycles during soft landings.

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

In addition, Rate-cutting cycles include a pause of at least three months as much as 70% of the time, and nearly half of the cycles include more than one pause.This indicates that Soft-landing rate-cutting cycles tend to be long (the share of cycles lasting more than one year is 50%), and follow a “fast first, slow later” pace, with central banks more inclined to make cautious, incremental adjustments as they approach the terminal rate.

Second, rising unemployment and a policy rate that is high relative to the neutral rate are important factors affecting the continuation of a rate-cutting cycle.Since the start of rate cuts, 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 effect on rate-cut decisions.

Third, In historical soft-landing episodes, central banks typically cut policy rates below neutral.At the end of a rate-cutting cycle, the policy rate averages 1 pp 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 below neutral.

Specifically, each 1-percentage-point increase in the unemployment rate raises the probability of cutting below neutral by more than 20 percentage points, while GDP growth and inflation have little predictive power for whether a 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 U.S. equity market is now clearly in 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 year-end outlook.

Some time has passed since the Fed’s remarks on Wednesday. It has largely delivered on its promises; what truly spooked the market was the dot plot for future policy released afterward.Looking back, this market move may actually have had another possible explanation.

Before Wednesday, U.S. stocks had been caught for several consecutive months in an extremely unhealthy, highly concentrated trade. Although market performance looked stable, as mentioned in notes recently, The U.S. equity market is now in a portfolio rebalancing period.

The past two weeks were 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 small catalyst for sellers who needed to reduce positions to start selling.

The reason for raising this possibility is that, looking back from today, Last week’s selloff actually occurred across all asset classes: profitable assets were sold, and all losing assets were sold as well.。Here is the key question: if the market was really trading the Fed’s revised dot plot and pricing in stickier inflation, then Gold should not have plunged nearly 2.5% on Wednesday.

If the Fed was really saying that inflation is sticky and will rise, Wednesday should have been a big up day for gold. But that did not happen; all kinds of assets moved in the same direction. In that case, it is more likely that portfolio 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 allocate, while all losing assets were taken off the books.

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

If that is what happened, the market should continue to rebound, and reallocation buying would lay the foundation for a year-end rally through the end of the year. Historically, the year-end rally typically does begin on 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 a lot of optimism, at least in the first half of the year, such as expectations of Fed rate cuts, more favorable tax policies under the new administration, and potential support for infrastructure.

The main issue is whether 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 earnings logic underpinning the U.S. equity market will no longer hold.

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

In fact, in many economies outside the U.S.—the euro area, the U.K., Asia and Japan—growth rates are close to recession levels: they are growing, but only barely. Meanwhile, U.S. economic growth is 3.2%, overwhelmingly outpacing almost every other country. This is why U.S. equities have attracted large inflows.But this anomaly—the growth divergence between other countries and the U.S.—is unsustainable.

Either other countries will make a concerted push and accelerate growth to catch up with the U.S.; or U.S. growth will slow to converge with theirs (This is the more likely scenario), because the current U.S. economic interaction mechanism is still one of importing deflation and exporting inflation. Over the next year, the U.S. will import deflationary pressure from the global economy into the U.S.,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. equities enter a late-cycle trade 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 earnings matter more than macro:https://www.meridianresearch.app/notes/75a9cbf5-8715-4f56-8722-9ee9c33dc638?ref=769bd1d1-1bdb-461a-89c9-e42c1ff5beebView note

2024.12.23

Monetary easing next year is underestimated

Expectations for monetary policy easing have cooled markedly. Fed funds futures are currently pricing in rate cuts of less than 40bp for 2025, a sharp downgrade from expectations of 125bp after the 9 50bp rate cut.​​

A large part of the adjustment is reasonable, but it has been too aggressive.

1) Market expectations for monetary easing in 2025 have fallen substantially​

2) But the inflation rebound has been exaggerated

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

From a monetary policy perspective, first, Unless tariffs generate significant second-round effects through wages or inflation expectations, the impact of the one-off increase in the price level caused by tariffs on inflation will disappear after about a year, putting it on a par with the repeated VAT hikes seen in other G10 economies, which typically leave no lasting mark on inflation or monetary policy.

Second, the trade war that occurred in 2018-2019 The trade war tightened financial conditions, prompting the Fed to ease. This cycle is different in many ways, but past experience shows that the monetary policy risks from tariffs are at least two-sided.The monetary policy risks from tariffs 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 U.S. punitive tariffs is also looming. Trade policy uncertainty has surged since the U.S. election, and manufacturing indicators have fallen further; this will will increase the likelihood of an industrial recession in the euro area.​​

6）Cushion the Hit from Higher US Tariffs？

Overall, US-Europe divergence is largely priced in, equities and credit will most likely continue to deliver positive returns, but given current high valuations, low hedging costs and the risk of a possible seasonal downdraft in the new year, it may be appropriate to increase hedge allocations somewhat Hedge allocations could be increased somewhat.

The real trade-weighted dollar is currently at its strongest level of the floating exchange-rate era, just below the pre-Plaza Accord peak in 1985. Despite the Fed’s hawkish repricing continuing to unfold, 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 in metals (iron ore may 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

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