The Real Obstacles to the Federal Reserve's Interest Rate Cuts

From the Perspective of Inflation to the Perspective of Interest Rate Transmission

Last night, the U.S. Bureau of Labor Statistics released the CPI data for September:

The U.S. CPI in September increased by 3% year-on-year, estimated at 3.1%, and the previous value was 2.9%; the U.S. CPI in September increased by 0.3% month-on-month, estimated at 0.4%, and the previous value was 0.4%.

Overall data fell short of expectations, clearing the way for further interest rate cuts in October.

As shown in the above chart, according to the dot plot from the Federal Reserve's September meeting, there are still two rate cuts expected by the end of this year, each by 25 basis points.

At the same time, the two-year U.S. Treasury yield remains around 3.49%, which is basically consistent with the implied benchmark rate in the dot plot.

Currently, the market has become accustomed to a narrative: The Federal Reserve is reluctant to cut rates due to concerns about inflation. In this article, we will take a different perspective and explore a new proposition: The issue of interest rate transmission to the ten-year U.S. Treasury yield.

Why adopt this perspective? As shown in the above chart, the total U.S. national debt has risen to $38 trillion. To alleviate debt pressure, the U.S. government is very eager to lower the issuance rate of new debt. However, lowering the federal funds rate can only reduce the issuance rate of short-term debt and may not necessarily lower the issuance rate of long-term debt, and could even have the opposite effect, causing long-term debt issuance rates to soar.

Therefore, for the Federal Reserve, the most critical issue is the interest rate transmission problem. If lowering the federal funds rate can lead to a corresponding decrease in the ten-year U.S. Treasury yield, then everyone is happy; conversely, if lowering the federal funds rate does not lead to a sufficient decrease in the ten-year U.S. Treasury yield, then the Federal Reserve is unwilling to act.

As shown in the above chart, in September 2024, the inversion between the ten-year U.S. Treasury yield and the federal funds rate is quite severe, so the Federal Reserve does not need to worry about transmission efficiency. Thus, the Federal Reserve boldly implemented a round of rate cuts.

However, after the Federal Reserve cut rates by 100 basis points, the ten-year U.S. Treasury yield began to exceed the federal funds rate. This indicates that transmission efficiency has significantly decreased. As a result, the Federal Reserve began to pause rate cuts. It wasn't until September of this year that the Federal Reserve resumed rate cuts, and it was a cautious "slow and steady" approach to cutting rates Overall, from the perspective of interest rate transmission efficiency, the issue of the Federal Reserve's interest rate cuts is very simple and clear: During the process of cutting interest rates, it is essential to avoid the ten-year U.S. Treasury yield being higher than the effective federal funds rate; otherwise, the rate-cutting process will spiral out of control.

The Issue of Risk-Free Rate Attribution

Thus, we have a new question: why did the U.S. not need to consider interest rate transmission issues before, but now it does?? This involves the issue of risk-free rate attribution.

If the interest rate on U.S. sovereign debt represents the risk-free rate for that term, then the U.S. does not need to consider interest rate transmission issues; conversely, if the interest rate on U.S. sovereign debt does not represent the risk-free rate for that term, then the U.S. must consider the issue of interest rate transmission.

Sovereign debt interest rate = risk-free rate + country credit spread

This transformation allows us to switch to a more intuitive micro scenario. For example, if a country's risk-free rate is 3%, a company with slightly poor credit quality has an interest rate of 5%, and a company with slightly better credit quality has an interest rate of 4%. Whether it is a poor-quality company or a good-quality company, there is a credit premium, and no one can bypass the risk-free rate to "cut interest rates."

Now the U.S. faces a very awkward identity transformation, as U.S. sovereign debt has lost its status as a risk-free rate. Thus, U.S. Treasury bonds are no longer special and cannot cut interest rates as freely as before.

As shown in the figure above, the ten-year U.S. Treasury yield is at 4.02%, while the dollar-denominated ten-year Chinese government bond yield is at 3.63%, with a difference of 40 basis points. This means that the attribution of the risk-free rate has temporarily shifted from the U.S. to China.

In other words, if Americans want to lower the ten-year U.S. Treasury yield, they must find a way to urge the Chinese to lower the dollar-denominated ten-year Chinese government bond yield. Otherwise, they will have to address the credit premium issue and reclaim the status of the risk-free rate. Clearly, the former is easier, while the latter is difficult.

As shown in the figure above, currently, China is also continuously lowering the dollar-denominated ten-year Chinese government bond yield, primarily by reducing the foreign exchange swap points of the dollar against the renminbi.

So how did the U.S. lose its status as the risk-free rate?? We discussed this issue in the article "The Deep Logic of Oil, the Dollar, and Gold."

As shown in the figure above, the true foundation of U.S. Treasury bonds is the price of oil. Unfortunately, the Russia-Ukraine war has become a stalemate, and to maintain pressure on the Russian economy, the U.S. has had to keep oil prices low for an extended period, which has somewhat undermined the foundation of U.S. Treasury bonds However, in the international financial market, strength is what matters. From the perspective of strength, U.S. Treasuries are weaker than Chinese government bonds, thus the U.S. dollar-denominated ten-year Chinese government bond becomes the risk-free rate for the critical ten-year term.

So, is this migration of risk-free rate attribution permanent? I believe that it is only temporary, after all, oil is the lifeblood of the modern economy. As long as the Americans firmly control the global oil supply order, U.S. Treasuries will have strong backing. Therefore, when the Russia-Ukraine war ends and the Americans regain control of the "oil price" card, the global pricing system will return to normal.

More Accurate Calculation of Rate Cut Space

Although the global pricing system will eventually return to normal, we still have to operate under a temporary system for now. That is to say, the transmission efficiency of U.S. interest rates is constrained by the U.S. dollar-denominated ten-year Chinese government bond.

The above chart shows the effective federal funds rate minus the U.S. dollar-denominated ten-year Chinese government bond yield, which we can define as the Federal Reserve's rate cut space.

If this value is below zero, it means that the federal funds rate is tightly constrained, and the Federal Reserve can cut rates; conversely, if this value is above zero, it means that the U.S. dollar-denominated ten-year Chinese government bond yield is tightly constrained, and the Federal Reserve cannot cut rates.

Currently, the market is in a peculiar equilibrium state. On one hand, the value of the Federal Reserve's rate cut space is around -50 basis points; on the other hand, the market expects the Federal Reserve to cut rates by another 50 basis points in the next two months.

Conclusion

Many people may feel that the above discussion is counterintuitive. How can the U.S. dollar-denominated ten-year Chinese government bond become the risk-free rate for that term? This only indicates that the impact of the Russia-Ukraine war is far more profound than we imagined. It has not only reshaped geopolitics but also the global financial pricing system.

The core issue facing the U.S. right now is not inflation, but rather, the massive scale of U.S. Treasuries lacking effective backing, which forces the Federal Reserve to maintain high federal funds rates. This is a very unfortunate approach, similar to how the Russian central bank had to quickly raise Russia's key interest rate to 20% at the beginning of the Russia-Ukraine war. In fact, the United States is also a participant in the Russia-Ukraine war, but the way it participates is different from traditional methods. The key battlefield for the mutual consumption between the U.S. and Russia is the international oil market. On one hand, the U.S. wants to maintain low oil prices; on the other hand, the U.S. aims to encircle and block Russian oil.

This war has lasted for more than three years, causing great suffering to the countries involved in the consumption. They have to maintain high policy interest rates to keep the attractiveness of their local currency long-term bonds. Therefore, Russia has to maintain high policy interest rates, and the U.S. also has to maintain high policy interest rates, unless both sides end the war and stop fighting completely.

In addition, this war has led to a bizarre phenomenon where the gold-oil ratio has broken through the conventional range of [10, 30], soaring to 76.4 at one point. This is because the main battlefield of the Russia-Ukraine war is not in the tangible eastern Ukraine region; rather, it is in the intangible international oil market.

In war, what is fought over is the economy.

In summary, we have clarified the real obstacle to the Federal Reserve's interest rate cuts—the prolonged and unresolved Russia-Ukraine war. If the Russia-Ukraine war ends next spring, global asset prices will undergo tremendous changes.

ps: Data from Wind, image from the internet

Author of this article: Cang Hai Yi Tu Gou, Source: Cang Hai Yi Tu Gou, Original title: "The Real Obstacle to the Federal Reserve's Interest Rate Cuts"

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