From December sixteenth, two thousand twenty-four to December twentieth, two thousand twenty-four

I. Foundation 

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

On the migration of debt on and off balance sheet

As a debt-resolution method, shifting debt on and off the balance sheet can help to some extent, but its substantive impact is indirect.

Shifting debt on and off the balance sheet can help resolve debt to some extent because, typically, The interest cost of off-balance-sheet debt is higher than that of on-balance-sheet debt. Thus, even if this shift does not reduce total debt, it lowers debt costs and can Free up some cash flow during the debt-resolution cycle to pay current wages or expenses.

On the other hand, the substantive impact of shifting debt between on- and off-balance-sheet categories is not especially significant. First, The actual interest savings are small relative to total debt; in an economy with a total size of 123 trillion, this would save less than 800 hundred million a year. Second, low interest rates are not cost-free in themselves, because The creditors for this debt are mainly the banking system within the economy; lowering the debt-service cost of off-balance-sheet debt therefore reduces banking-system income.。

If the banking system is capitalized independently, this transfer means an actual transfer of funds from the banking system to the entity resolving the debt.

If the banking system itself also needs a capital injection, the result is this: the entity resolving the debt saves some funds, while those savings are almost entirely offset by the funds that need to be injected into the banking system, leaving no substantive, fundamental change in the economy.

2024.12.19

II. Insights 

Our Viewpoints and ideas on market.

On post-cycle trading: not a new cycle, but an extension of the current one

Fed rate cuts and stable business-cycle indicators will drive more balanced growth and performance across the U.S. equity market in 2025, though that balanced growth may be concentrated more in large caps than in small caps. History shows that sustained small-cap outperformance usually occurs in an early-cycle environment, alongside the end of the labor cycle and rate cuts of several hundred basis points. The current environment does not have these characteristics.

The pace of earnings growth is an important clue to where we are in the business cycle.

S&P 500's EPS Growth typically bottoms at one of two levels, near 0%, or between -15% and -25%. Small caps are more volatile, with more pronounced swings in their troughs and peaks.

Chart: The current pickup in earnings growth starting at 0 is characteristic of a late-cycle extension

The key determinant of which type of bottom forms is whether the labor cycle shocks the economy.

When the labor cycle involves rising unemployment, as shown by the dashed circles above, earnings troughs are usually deeper. If the labor market experiences no material shock (solid circles), the trough is shallower.

The current inflection point in earnings growth has rebounded from near the zero line, meaning it has not been dragged down by an unemployment cycle. This indicates that the current economic cycle has not ended but has continued along its expansion path. In other words, This is growth acceleration after a “soft landing.”

However, it is worth noting that, given the persistent tightness of the labor market, This renewed acceleration in earnings growth today may be a typical late-cycle extension, that is, an extension of the post-cycle phase.

Historically, earnings growth accelerations in this post-cycle phase have usually been driven by forces unique to a particular cycle.

The tech-equipment spending boom in the late 1990s drove earnings growth, but that momentum did not persist as it spread through the economy; the rebound after the earnings trough in 2015 benefited from a global growth recovery fueled by China's large-scale fiscal stimulus and a boost from U.S. tax reform in 2017.

In the current cycle, the recovery in earnings growth depends more on a small group of large-cap, quality names, which benefit from AI capital spending, cost cuts, and improved operating efficiency.

Chart: Reposting the chart from yesterday's Weekly Wrap

The ratio between the S&P 500 equal-weighted index and its market-cap-weighted index is a classic illustration of this trend, and this ratio has consistently reflected late-cycle market characteristics over the past few years. Although the market rebounded from its “recession scare” lows this summer, the ratio has recently started to fall again, suggesting that a broadening of earnings growth may be more a 2025 story than something achievable in the fourth quarter of 2024.

Chart: Equal-weighted relative performance has not shown sustainable growth

Looking at forward-looking indicators of earnings growth, small-cap stocks and lower-quality companies (Lower Quality Areas) have also seen EPS growth bottom, but their rebound has been clearly weaker than the S&P 500. This further confirms that the current environment remains late-cycle:

At this stage, profits are harder to come by for lower-quality companies, higher price levels, persistent labor-cost pressures, and rising real interest rates raise the key question: can earnings growth at ordinary companies reaccelerate?

It probably can, but the center of gravity for earnings growth will still favor large caps, and that growth may be more idiosyncratic than the market consensus expects, meaning It is better to focus on high-earnings-quality cyclical stocks (Quality Cyclicals) than to chase lower-quality cyclicals.，The latter's performance often depends on larger adjustments in interest rates and labor costs, conditions that are not yet fully in place in the current macro environment.

The broadening of earnings growth across the market remains at an early stage. In the short term, the main drivers of the earnings recovery remain concentrated in high-quality companies with pricing power, cost control, and efficiency advantages. Watch for the relative disadvantages of lower-quality names caused by structural constraints such as high costs and limited access to capital; prioritize companies that can generate excess returns in the current environment through innovation and operating leverage. This divergence is characteristic of a late-cycle phase.

Yesterday's Weekly Wrap for last week (if you haven't read it, you really should!!)also discussed our concerns about current market breadth. In a post-cycle phase, large caps are bound to benefit first as market participation broadens;If nothing else new emerges, the small-cap trade may be about done once this Trump-driven wave passes.

2024.12.16

A historic rally in Chinese government bonds

Since 12, Chinese government bonds have become a global focus, staging a historic rally.

The 10-year government bond yield (CGB 10y) quickly broke below key support, successively falling below 2.0% and 1.8% and heading straight for 1.7%; the 30-year government bond yield also fell below the 2% threshold last Friday.

 Chart: Entering 12, CGB yields and Repo IRS broke through key levels, with a powerful rally

The rally began with the announcement of the interest-rate self-regulatory mechanism, with policy signals clearly indicating a shift to “moderately accommodative” monetary policy. Subsequent Politburo and Central Economic Work Conference meetings further confirmed this direction, We said before the meetings that rather than focusing on policy texts, it was better to watch the bond market as it resumed its one-way move.

Importantly, this rally differs in many ways from the move in 9.

In September, the market still had high hopes for fiscal policy and focused mainly on fiscal stimulus, causing a bear steepening of the curve (long-term yields rose). This time, the move is driven purely by monetary policy, and expectations are now fully established for 2025 7 OMO rates and a 50bps cut in RRR.

 Chart: The comparison between 10-year CGB yields and 7D OMO rates shows that the market expects further rate cuts

Another interesting development occurred from the end of 11 to the beginning of 12.

At the time, the CNH DF curve corrected significantly, especially after Trump's election win, and the front end of DF failed to break through the year's highs convincingly.On 12 10, buying in the London session began to push the curve higher, particularly as T/N (Tom Next, or overnight swaps) rose rapidly. 12 11 then saw an unusual price move.

Chart: The front end DF failed to substantially break YTD highs 

The unusual market moves prompted broad buying interest.

Rumors fueled the move:It was said that Chinese policymakers were considering allowing the renminbi to depreciate in 2025 in response to Trump's tariff reinstatement. The news immediately sent USDCNH (the offshore renminbi/U.S. dollar exchange rate) sharply higher to 7.29, pushed T/N prices all the way up to +2, and sent short-term implied yields for 1 months surging 80bps to 3.2%.

Put simply, it means Over these few days, fears of renminbi depreciation triggered urgent hedging, renminbi liquidity became scarce, driving up short-term funding costs (i.e., T/N).

That evening, an official channel affiliated with the central bank published a denial, stressing that “the renminbi exchange rate has a stable foundation.” The USDCNH exchange rate subsequently retreated, but the DF curve remained firm.On 12 12 and 13, the front-end curve tested the year's highs twice without breaking through. Profit-taking then emerged, and the curve quickly corrected.

Chart: The offshore-onshore 1y swap spread has widened to April highs

However, T/N remained firm, briefly reaching +12 during the London session, reflecting a growing divergence in market views on short-term renminbi liquidity, while the rise in T/N was driven more by the Politburo meeting. Its positive signals attracted overseas capital into Chinese equities.

But as Chinese equities weakened after the Central Economic Work Conference, sentiment softened and capital flows slowed. T/N fell back to around +0.5, and the DF curve declined further.

T/N fluctuations reflect short-term supply and demand in the renminbi funding market. This episode was influenced not only by exchange-rate rumors but also closely linked to capital flows in Chinese equities. When expectations of renminbi weakness emerge and inflows into equities slow, T/N moves sharply, reflecting rapid shifts in market sentiment.

The final question is whether the rates market has rallied too far, and how to view the outlook.

The point of disagreement in the market is this:On the one hand, bond-market yields have fallen rapidly in the short term by 20-30bps and are already approaching historical lows. Some investors are beginning to worry that the PBoC will suppress a one-way move, as it did this summer. On the other hand, the low-interest-rate policy stance is already clear, and room for further rate cuts remains.

Historically, the spread between the 10-year CGB yield and the 7d OMO rate is usually around 50bps.

If 2025-year 7d OMO really cuts 50bps, then 10-year CGB still has some room to fall, but the risk-reward at current levels is no longer as attractive as before.The bond market still has some upside, but the short-term rally has been too rapid and profit-taking pressure is building. Be more cautious about chasing prices at current levels and wait for a better entry point.

2024.12.17

U.S. equities look overvalued from a macro perspective

The S&P 500 is up YTD this year by 27%, with both its absolute level and macro-consistent valuation relatively close to historical highs.

Macro valuation (that is, a measure of whether equity valuations are high or low relative to macroeconomic drivers) is more useful than valuation metrics alone, because value means something different to everyone, while the spread is obvious.

GS previously introduced a macro valuation model (Macro and Equity Valuations: Tailwinds Behind, Headwinds Ahead) (also posted in the community) showing that The 10Y Treasury yield, unemployment rate and core inflation—the three key variables, along with a slowly changing demographic variable—can explain the valuation trend of the S&P 500 quite well, with current valuations deviating significantly from the model’s expectations, second only to the dot-com bubble at the end of the 90s.

Chart: The model’s projections suggest that U.S. equities are in fact overvalued relative to the macroeconomic backdrop, according to GS

The market may be pricing in productivity growth driven by AI ahead of time, but this logic has not yet shown up in clear earnings growth. Excluding this optimistic assumption, current valuations remain overextended.Even under a favorable macroeconomic scenario in which bond yields fall, core inflation recedes and the unemployment rate stays low over the next 12 months, these factors would add only about 4% to real returns in the model, while high valuations would be a 7% drag.

This means nominal returns in 2025 may be only around 4%, with little room for further beta expansion.

High valuations alone are not really a problem, the key is that in this situation any negative effects will be amplified during an economic downturn:

Chart: High valuations make the market more vulnerable to cyclical deterioration

History shows that high valuations have a more pronounced negative impact on the market when the economy deteriorates.

2025 is marked by significant uncertainty, especially risks related to potential policies from the incoming administration. Broad tariffs are one of the largest tail risks; if implemented, they could push core inflation up significantly, weigh on GDP growth and raise the unemployment rate.

According to the model, U.S. equities could face a high-single-digit decline in this scenario. Even if bond yields fall under pressure, the hedging effect would be limited.

Chart: Implied volatility in DM equities and some currencies is near the lower end of its historical range

Implied volatility in developed-market equities has fallen back to the lower end of its historical range, reflecting reduced market expectations of short-term volatility risk. Implied volatility in some major currency pairs is showing a similar trend, especially for currencies supported by policy stability and macroeconomic factors.This low-volatility environment may make the market more sensitive to unexpected events; if an external shock occurs, volatility could rebound rapidly.

The market has already revised US growth upward to some extent on a cyclical basis, but an economy nearing “full capacity” means there is limited room for further upside. Although the macroeconomic outlook supports the baseline case for being long US equities, we want our community members to pay attention to the downside tail risks from valuation overstretch.

Especially when the market challenges the current optimistic macroeconomic expectations (for example, policy risks or deteriorating growth expectations), the emergence of such risks could make a market correction more severe.

USD can serve as a bet on outperformance in US growth while also providing a natural hedge against potential policy tail risks (such as tariffs or higher US rates).

2024.12.18

III. Market Pulse 

Our latest Comments on the economic and market environment

Russell 2k Futures: Demand fails to support a rebound

At the start of 12, futures demand unexpectedly rebounded despite continued weakness in the Russell 2k index.

According to Commitment of Traders (COT) data, net buying totaled 21 hundred million dollars from 12 3 to 10, driven mainly by new long positions. This demand extended the 7.15 hundred million dollars in position growth from the previous week.However, as prices fell further, these newly established long positions faced the risk of deeper unrealized losses and urgently needed support from the Fed or market sentiment to prevent further deterioration.

Specifically, from 3 12 to 10, the Russell 2k fell -1.4%, underperforming the S&P 500 (-0.2%) and Nasdaq (+0.7%). Despite this, long-position additions were significant: Asset Managers (6.4 hundred million dollars), Hedge Funds (10 hundred million dollars) and other categories (4.6 hundred million dollars) were all net buyers; only Non-Reportable accounts reduced positions slightly, by 3500 ten thousand dollars. These inflows were consistent with the relative change in the funding differential. During the same period, the Russell 2k’s financing cost showed a persistent discount advantage over the S&P 500.

But demand failed to translate into price support.From 12 10 to 17, the Russell 2k fell a further -2%, continuing to lag the S&P (+0.3%) and Nasdaq (+3%).Notably, even though flows remained relatively robust during this period, actual performance failed to deliver, suggesting a subtle shift in market sentiment.

Before 12 16, the Russell 2k’s funding performance kept improving on both an absolute and benchmark-relative basis, with its discount at one point reaching a high not seen in more than 1 years. But this advantage reversed sharply on 12 17; the one-day decline was among the largest since 2024, partly due to liquidity fluctuations caused by quarterly futures rollovers.

At this stage, recently established long positions face significant challenges Without further macroeconomic tailwinds or Fed support, these positions could fall further underwater.As of now, the Russell 2k’s funding discount to the S&P 500 remains about 20bps higher than at the start of the month. In light of recent flows and basis changes, Market expectations for the Russell 2k to the downside may take longer to adjust.

We have also discussed how the various indexes are performing in the market in our community’s U.S. equities group:

Original discussion link:https://www.meridianresearch.app/notes/dfb3102a-6e96-4576-b33f-25a7238a079c?ref=769bd1d1-1bdb-461a-89c9-e42c1ff5beebView note

Chart: Russell 2k 3-month funding vs. Fed funds

Chart: Russell 2k vs. S&P funding

2024.12.18

What We Are Seeing Post FOMC

Powell’s hawkish stance weighed on markets, yields surged and curves bear-steepened; U.S. equities weakened across the board, with Bitcoin-sensitive sectors posting the steepest losses (-11.29%), while non-profitable tech fell 6.38%. VIX rose to 19, credit spreads widened, and market expectations for 2024 cuts in FED were revised down further, with fewer than two rate cuts priced in at present (-31.5bps).

Two statements from the meeting were particularly important:

1. “In developing new projections, ‘some people did take a very preliminary step and start to incorporate highly conditional estimates of economic effects of policies into their forecasts at this meeting,’ Powell said…”

In developing new economic projections, some members of the Federal Reserve took preliminary steps to incorporate the possible economic effects of certain policies into their forecasts. These estimates are Highly conditional (highly conditional), indicating a high level of uncertainty in the forecasts, with the specific effects depending on actual policy implementation and the economy’s response.

2. ”…of an outlook in which U.S. central bankers anticipated a higher inflation outlook and fewer rate cuts next year.”

Against this backdrop for the projections, The Federal Reserve expects inflation to be higher in the future, while the expected number of rate cuts may be lower.

Powell sent a clear signal: fighting inflation takes priority over growth.

1) Inflation expectations worsen: The Fed raised its forecast for core PCE in 2025 from 2.1% to 2.5%, while lowering its unemployment-rate forecast (U3) to 4.3% (previously 4.4%). This suggests monetary tightening could persist longer than the market expects.

2) Policy maintains a “high bar”: The statement specifically referred to “the extent and timing of additional adjustments,” suggesting the policy path may remain unchanged unless inflation or employment data improve significantly.

3) Rate-cut expectations narrow: The market is currently pricing in fewer than two rate cuts in 2024 (-31.5bps),Powell used the word “restrictive” as many as 10 times, further dampening expectations of monetary easing.

Chart: After Powell, the market now prices in only 31.5 bps of FED cuts for all of next year

Two direct market consequences.

1) U.S. Treasury yields surge:Curves bear-steepened at both the short and long ends; yields on the 10-year and 30-year Treasuries broke above post-election highs, becoming a major obstacle to further equity gains. The front-end adjustment (Dec SOFR) is nearing completion, but rising long-term yields are putting pressure on high valuations.

2) Santa Rally faces an obstacle:The market had previously expected a “Santa Rally” at year-end, but this hawkish shift has made it significantly harder for the rally to continue. Current SPX valuations of 22x require a combination of accommodative policy and a strong economy, while the adjustment in FOMC has weakened that prospect.

Overall, although technical factors remain supportive (inflows + long gamma), and further stabilization in VIX could favor a short-term rebound, the likelihood of the market reaching new highs has fallen sharply.With the Federal Reserve continuing to emphasize that fighting inflation comes first, further gains may require stronger economic and policy catalysts. After a strong year-to-date performance, a more cautious stance should be adopted.

2024.12.19

BOJ decision: genuinely unexpected

The BoJ’s decision yesterday surprised the market. Recent economic data have been strong, downside risks to the U.S. economy have clearly diminished, and the Fed’s overall stance has shifted. The market had in fact widely expected the Bank of Japan to raise rates at this meeting, but the BoJ ultimately decided to leave the current rate unchanged.

Ueda emphasized at the press conference, mainly that the delay in raising rates was intended to confirm the momentum in wage growth before next spring’s wage negotiations, as well as to account for uncertainty surrounding the new U.S. administration.As for wage growth, the data cannot be confirmed until 3 next year at the earliest, or even later, so this point remains quite vague. Ueda offered no clear path to resolve the uncertainty around the new U.S. government’s policies, prompting the market to question the BoJ’s forward guidance.

He also said the BoJ did not need to wait for specific data to make a decision, but did not elaborate further on the criteria for that judgment or make a clear commitment regarding the timing of future decisions.

The yen depreciated sharply during the policy meeting, and its accelerated decline prompted questions at the press conference. Ueda replied that the impact of exchange rates would be considered, particularly their effect on the stability of import prices. Nevertheless, he said current data trends were positive and that “a little more” information was needed to make a rate-hike decision, suggesting that a rate hike remains on the way.

Our view has consistently been that a rate hike by BOJ would most likely come in January next year. Although there is considerable uncertainty, it is unlikely to be delayed further.From a policy-communication perspective, this BoJ decision will certainly weaken the market’s confidence in its transparency; in effect, it draws down its credibility.

Trading the yen’s continued depreciation is essentially trading this loss of credibility, because the market will have serious doubts about BOJ from now on.

There are two resistance points for a straight-line yen depreciation trade. The first is verbal intervention by Japan’s Ministry of Finance (MoF); the second, a little more than two hours later, is the time when actual intervention occurs.

Single stocks on the Nikkei board have not moved much. Yen depreciation has a positive effect on Nikkei trading, and the market continues to favor sectors benefiting from the BoJ’s dovish policy, such as real estate, exporters, highly leveraged companies and tourism. With rate hikes delayed, banks and financial stocks continue to be sold, Trading before January broadly follows this logic: cyclical sectors > defensive sectors, large caps > small and mid caps.

As for the yen, the market has not priced in as much for January as we expected, which means trades chasing further depreciation may persist. Japan’s next potential intervention target could be around 160.

Note that liquidity in the Japanese market may tighten starting next week, particularly from 12 24. This imbalance recurs each year during Japan’s repo blackout period (the final 5 trading days of each quarter), affecting the market’s supply-demand balance and increasing near-term volatility risk.

2024.12.20

Note: All content in this article 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.