China Galaxy Securities: The Fed may wait a little longer to cut interest rates as scheduled in May

The Zhitong Finance App learned that China Galaxy Securities released a research report saying that at the 3rd FOMC meeting of the year, the Federal Reserve announced that it would maintain the federal funds interest rate level at 4.25%-4.50% and continue to reduce through quantitative austerity (since April, the scale of treasury bond purchases has slowed from 25 billion US dollars/month to 5 billion US dollars/month), which is in line with market expectations. Since the May meeting did not announce the economic outlook and bitmap, and the incremental information it provided was limited, the Federal Reserve still tends to “rely on hard data” in the short term, which also means that it is difficult to cut interest rates in the first half of the year.

Overall, the message conveyed at this meeting was not significantly different from March. Except after the announcement of equal tariffs in April, the Federal Reserve faced greater uncertainty and risk of stagnation. Although short-term officials rely more on hard data that has yet to weaken, looking at the whole year, when aggregate demand is likely to shrink due to tariffs and the government's attempt to cut spending, the Fed will still cut interest rates two to three times in the second half of the year, but the probability of the first rate cut in July is also decreasing.

The main views of China Galaxy Securities are as follows:

The Federal Reserve's main concern is still stagflation, but internal opinions may split into two groups

Taken together, the Federal Reserve still repeatedly emphasized the risk of “stagflation” during this meeting, focusing more on hard data that has yet to show a clear decline, nor has it given clear guidance on when to cut interest rates. After the implementation of equal tariffs in April and seriously disrupted market expectations, soft data showed that short-term inflation expectations in the private sector rose markedly, while weakening consumption and investment expectations also suggested a rise in the future unemployment rate; on the other hand, GDP and labor market data for the first quarter still did not weaken significantly, and the impact of tariffs on economic growth inertia has not yet been reflected. In a situation where it is impossible to determine the extent of US stagnation caused by tariffs in the first half of the year, Powell is inclined to stand still.

It should be noted that the Federal Reserve's internal tariff impact appears to be divided into two groups. The first group is headed by Powell, most officials who are concerned about a recovery in inflation and rely on hard data; the other group is a small group of officials represented by Governor Waller, who believe that inflation is temporary and needs to start hedging interest rate cuts before the hard data deteriorates significantly.

4 aspects worth paying attention to in this conference

(1) The huge uncertainty caused by tariffs has been further emphasized, and the Fed's concerns about stagflation are rising. The most obvious change in the May FOMC meeting statement from March was the impact of equal tariffs in April, which emphasized that the uncertainty facing the economy continued to rise (Continued about the economic outlook has continued to rise).

(2) Compared to soft data, the Fed relies on hard data for short-term observations. This also means that the probability of cutting interest rates in the first half of the year is lower, and the possibility of cutting interest rates in July is also declining. In the opinion of the “two factions” of the Federal Reserve, the attitude of carefully observing hard data, preventing the risk of inflation recovery, and not rushing to cut interest rates dominates the mainstream.

(3) Powell did not indicate which is more important to the Federal Reserve, inflation or labor data, nor does he have clear guidelines on how to cut interest rates, but the labor market may be more critical.

(4) Compared to the Federal Reserve, tariff negotiations and fiscal policy are more important in the short term. Judging from the length of trade negotiations in US history, the average time from beginning communication with the US in 2016 and earlier to the final signing of a free trade agreement was 18 months, with the shortest being 4 months. This also means that this round of tariff communication will actually make general and substantial progress until at least the third quarter.

The impact of two potential interest rate cut paths on asset prices?

On the market side, CME data shows that the interest rate cut expectations of federal funds rate futures traders are relatively stable. They continue to maintain the expectation that interest rate cuts may occur 3 times within 2025, with the first rate cut in July. The three major US stock indexes collectively closed higher; US bond yields declined, falling 2.52 BP to 4.267% for the 10-year term, 1.24 BP to 3.770% for the 2-year term; and the US dollar index rose to 99.9006. The market did not expect much from the meeting, but was happy to see that the Federal Reserve did not make a more hawkish assessment after the tariffs were implemented. However, it should be noted that if the Federal Reserve relies on hard data, then the expectation of the first rate cut in July may still be overly optimistic.

In terms of assets, the Federal Reserve does not seem to be able to provide support through monetary easing in the short term, and the timing of interest rate cuts in the second half of the year is still uncertain. We might as well consider two ways to change monetary policy without significant reduction in tariffs: (1) the Federal Reserve adheres to the current principle of data dependence and cuts interest rates at the end of the year after the economy deteriorates; (2) the Fed gradually favors Waller's view and cuts interest rates ahead of time to protect economic growth.

In the first case, equity assets may fall again as profit expectations decline, until the economy deteriorates to the point where the Federal Reserve begins to cut interest rates rapidly and the Trump administration's tax reduction expansion policy is substantially implemented; long-term US bond yields may fluctuate and decline as economic expectations decline, and after rapid interest rate cuts begin, they may weaken at an accelerated pace, stabilizing below 4%; the US dollar index maintains a similar pace to US bonds, and the center continues to weaken.

In the second case, the Federal Reserve may consider cutting interest rates moderately at the beginning of the second half of the year. Equity assets are more likely to observe economic trends in the form of shocks. If interest rate cuts can mitigate the impact of tariffs on the economy and tax cuts are implemented, equity assets may restart upward; in terms of long-term US bond yields, then rebound again under the pressure of improved aggregate demand and fiscal expansion, and the center remains around 4%; however, unlike US bond yields, the US dollar index may still weaken but weaken under the Trump administration's long-term reform framework The magnitude is lower than in the first case.

Currently, the probability of the first situation occurring is higher, that is, the Federal Reserve can still start cutting interest rates in the second half of the year, but the probability of cutting interest rates for the first time in July is weakening. On the one hand, this is due to the fact that tariff negotiations are still progressing slowly. On the other hand, the continuation of the inertia of US economic growth combined with private sector inventories buffered the rise in inflation and the decline in the labor market, and the Federal Reserve did not necessarily have enough data to determine whether interest rates should be cut in July. However, it is still believed that the center of inflation in 2025 will not be significantly higher than the range of 3.0%-3.5%, nor will it affect the long-term center of inflation, so monetary policy will not continue to be tight, and the Federal Reserve can still cut interest rates by 50-75BP during the year.

Risk Alerts

1. Risk that the US labor market and economic data will decline beyond expectations; 2. Risk of unexpected liquidity problems in the US banking system; 3. Risk of Trump's policy exceeding expectations and stimulating inflation