CICC: The "Next Step" of the Federal Reserve

At the conclusion of the October FOMC early this morning Beijing time, the Federal Reserve further lowered the benchmark interest rate by 25 basis points to 3.75-4%, fully in line with market expectations [1]. Additionally, the Federal Reserve announced its decision to stop reducing its balance sheet starting December 1. As the market had fully priced in this rate cut, the implied probability of a rate cut in October from CME interest rate futures was close to 100% before the meeting, and there was also discussion about halting the balance sheet reduction. Therefore, the rate cut and the cessation of balance sheet reduction were not surprising; in contrast, the market's focus was more on the subsequent rate cut path.

On this point, the meeting was somewhat hawkish. Powell indicated that there is increasing disagreement within the Federal Reserve about whether to continue cutting rates in December, with more people believing that it might be better to wait. The market reacted strongly to this, with U.S. Treasury yields rising sharply by nearly 10 basis points, the dollar also climbing, and U.S. stocks and gold experiencing slight adjustments.

Chart: Implied probability of a rate cut in October from CME interest rate futures close to 100% before the meeting

Source: CME, China International Capital Corporation Research Department

Core information from this meeting: Continue to cut rates by 25 basis points, halt balance sheet reduction to prevent liquidity shocks

Continuing to cut rates by 25 basis points to 3.75-4% fully aligns with market expectations. In the September FOMC, Powell mentioned that the downside risks to the labor market were increasing while continuing to highlight inflation risks, with the decision-making balance tilting towards employment (《How Many More Times Can the Federal Reserve Cut Rates?》). Since October, the government shutdown has led to a "missing" non-farm payroll report, with September's "small non-farm" ADP employment increasing by only 32,000, significantly below market expectations, indicating that the labor market is still slowing. Meanwhile, last week's September CPI was overall below expectations, dispelling market concerns about inflation spiraling out of control due to the general tariff escalation in August, thus "clearing the obstacles" for this rate cut. Therefore, in the context of a slowing labor market and declining inflation, a 25 basis point cut in October had become market consensus, with the implied probability of a rate cut in October from CME interest rate futures close to 100% before the cut. Powell also stated at the press conference that the labor market is gradually cooling, but the overall economic situation is still good, continuing to expand moderately.

Chart: September's "small non-farm" ADP employment increased by only 32,000, significantly below market expectations

![](https://mmbiz-qpic.wscn.net/sz_mmbiz_png/fzHRVN3sYs9XjJQdvYbJBKL1XSqibVywEPXY2oicF5Rksoials3CDuy2TdYr6yftXMZXnpllf6nVmawH8VuHoLnGQ/640? Data Source: Haver, China International Capital Corporation Research Department

Chart: September U.S. CPI unexpectedly fell, "clearing the obstacles" for interest rate cuts in October

Data Source: Haver, China International Capital Corporation Research Department

Announced the halt of balance sheet reduction to prevent liquidity shocks. The Federal Reserve announced at this meeting that it would stop reducing its balance sheet starting December 1 to avoid repeating the "cash crunch" of 2019 amid current tightening liquidity conditions. Powell stated in a public speech on October 14, "When reserves are slightly above ample reserve conditions, balance sheet reduction should stop, and this level may be reached in the coming months, with liquidity gradually tightening" [2]. Recent signs of tightening U.S. dollar liquidity include:

► From the "price" perspective: The repo rate has significantly increased, with the SOFR rate rising to a peak of 4.5%, and the SOFR-OIS spread has also widened significantly, indicating that liquidity in the repo market has tightened.

Chart: Recent widening of the SOFR-OIS spread indicates tightening liquidity in the repo market

Data Source: Bloomberg, China International Capital Corporation Research Department

► From the "quantity" perspective: Reverse repos are nearing exhaustion and will no longer be able to offset balance sheet reduction. U.S. financial liquidity consists of three parts: securities or loans held by the Federal Reserve, the Treasury General Account (TGA), and overnight reverse repos (ONRRP), with the difference among them approximating bank reserves (see U.S. Stocks Losing Liquidity "Support"). However, 1) since the debt ceiling issue was resolved, the Treasury has issued bonds to replenish the TGA account, with the TGA balance rising from $260.8 billion in June to the current $964.8 billion, absorbing financial liquidity; 2) The Ministry of Finance has increased the issuance of short-term bonds, combined with the Federal Reserve's interest rate cuts, leading money market funds (MMF) to shift more funds towards short-term bonds. The usage of overnight reverse repos has decreased from a peak of $460.7 billion at the end of June to the current $5.5 billion, which will no longer be able to continue to hedge against balance sheet reduction.

► In addition, the recent failures of some regional banks in the United States have heightened market concerns about liquidity. On October 16, local time, two regional banks, Zions Bancorp and Western Alliance Bancorp, reported loan defaults, increasing market worries about private credit and liquidity.

In our article "How will the Federal Reserve end balance sheet reduction?," we pointed out that measuring adequacy by the ratio of reserves to bank assets, the critical point for excessive and moderately adequate reserves is 12%-13%, while the warning line for transitioning to a lack of reserves is 8%-10%. This ratio dropped to as low as 7.94% during the "cash crunch" in September 2019, forcing the Federal Reserve to expand its balance sheet (by purchasing short-term bonds). The current level is 12.2%, just close to the line mentioned by Powell that is slightly above the ample reserves threshold, thus the Federal Reserve has chosen to stop balance sheet reduction to prevent a recurrence of liquidity crises in the repo market similar to that of 2019. Ending balance sheet reduction can alleviate financial liquidity in the United States, and according to our model, this is marginally beneficial for the overall U.S. stock market.

Chart: Since the Federal Reserve began balance sheet reduction in June 2022, the size of the balance sheet has shrunk by $2.3 trillion.

Source: Bloomberg, China International Capital Corporation Research Department

Chart: Measuring U.S. financial liquidity by the Federal Reserve's liabilities - TGA - reverse repos, indicating a tightening of financial liquidity.

Source: Bloomberg, China International Capital Corporation Research Department

Chart: The current reserve ratio to total bank assets is 12.2%, reaching the critical point of excessive and moderate abundance.

Source: Wind, China International Capital Corporation Research Department

Chart: Overnight reverse repos are nearly exhausted and will be unable to continue to offset balance sheet reduction.

Source: Bloomberg, Wind, China International Capital Corporation Research Department

Future Policy Path and Space: Neutral interest rate calculations indicate room for 3 more rate cuts, but the pace may slow; the new Federal Reserve Chair is the biggest variable.

The biggest "surprise" in this meeting was Powell's statement about the possibility of pausing rate cuts in December. However, from Powell's perspective, it may not be so surprising. The rate cuts initiated in September were a "necessary move" due to suddenly increasing employment pressures, but Powell believes that inflation pressures have not been completely alleviated. After two consecutive rate cuts in September and October, interest rates have been adjusted to respond to the "known" employment pressures, but the government shutdown does not provide more "new" information. Therefore, Powell is concerned about "driving too fast in foggy weather," which could be counterproductive. In this sense, the Federal Reserve seems to have reason and motivation to pause rate cuts in December and observe subsequent changes.

Our consistent view is that the Federal Reserve needs and can cut rates (after all, high rates and weak employment are facts, and tariffs have an impact on inflation but the transmission is slow), but it does not need to cut significantly (moderate adjustments can lower financing costs below returns). In this case, the path of rate cuts is indeed a major variable. The Federal Reserve could initiate rate cuts due to one or two unexpectedly poor non-farm payroll data, but it could also wait to observe the effects due to temporary data absence or not being so poor ► Under "natural conditions," we estimate that the Federal Reserve still has room for 3 rate cuts in this round, corresponding to long-term interest rates of 3.8% to 4.0%. The current difference between the actual interest rate in the U.S. and the natural rate is 0.8%. A further 3 cuts of 25 basis points each could bring financing costs and investment returns to "par," corresponding to a nominal neutral interest rate of 3.5%. Assuming a term premium of 30 to 50 basis points, this corresponds to a 10-year U.S. Treasury yield of 3.8% to 4.0%.

► The short-term rate cut path will depend more on the government shutdown and data, such as when the government shutdown is resolved to disclose new employment data, and the subsequent path will also be influenced by inflation trends. Unlike previous "preventive" rate cuts, current inflation, although affected by tariffs, has a slow and small transmission. As of September, the proportion of tariffs borne by U.S. consumers is around 13%. We previously indicated that although long-term uncertainty has increased, a short-term agreement may be reached because the "irrational" high tariffs are no different from a "trade embargo," which both China and the U.S. cannot bear in the short term (see "Impact and Response to Tariff Escalation"). The recent results of the China-U.S. negotiations in Kuala Lumpur also confirm our viewpoint. U.S. Treasury Secretary Yellen stated that the plan to impose a 100% tariff on China has been canceled [4]. We estimate that under this scenario, the U.S. CPI year-on-year may fall from 3.2% to 3.1% in the first quarter of next year, while core CPI year-on-year remains at 3.4%, which should not pose too much resistance to subsequent rate cuts.

In contrast, the new Federal Reserve Chair and the independence of the Federal Reserve are the biggest variables for the rate cut path next year, which may increase policy uncertainty after the second quarter of 2026. From a timeline perspective, the nomination process for the Federal Reserve Chair is expected to officially start in the first quarter of 2026. The current Chair Powell's term will expire in May 2026. If the White House completes the nomination early in the year and it is approved by the Senate, the new Chair could start to lead monetary policy as early as after the FOMC meeting in mid-June. Currently, the range of candidates that the market is focusing on has clearly narrowed to about five [5] (Kevin Hassett, Kevin Warsh, Christopher Waller, Michelle Bowman, Rick Rieder). Both Waller and Bowman, current Federal Reserve governors, are more dovish, so it is not ruled out that the new Chair may cut rates more than expected due to political factors, which is also the reason why the policy path after June is currently difficult to judge.

Chart: The current difference between the U.S. actual interest rate and the natural rate is 0.8%, corresponding to 3 rate cut spaces

Data source: Wind, Bloomberg, China International Capital Corporation Research Department

Chart: We expect the year-on-year U.S. CPI in the first quarter of next year to fall from 3.2% to 3.1%, while the core CPI year-on-year remains at 3.4%.

Data source: Haver, Bloomberg, China International Capital Corporation Research Department

Economic and Asset Implications: "Loose Trading" faces short-term setbacks, while "Recovery Trading" gradually takes over; U.S. stocks are not pessimistic, U.S. bonds need to wait for interest rate cuts, and the U.S. dollar slightly strengthens in the fourth quarter.

In the short term, the market's cooling expectations for a rate cut in December will hinder "loose trading," unless the government shutdown ends and more data is released to reinforce rate cut expectations (see "What Happens After a Rate Cut? A Discussion on Historical Experiences of Rate Cuts").

Correspondingly, "recovery trading" is expected to gradually take over, as the Federal Reserve's rate cuts will help restore traditional private demand such as real estate and manufacturing investment (recent Markit PMI and existing home sales have already begun to show signs of recovery). However, the speed of recovery depends on the pace of easing. Overall, the direction is clear; subsequent fiscal efforts and the continuation of technology investment trends may together promote the gradual recovery of the U.S. credit cycle, which has important implications for asset trends in the fourth quarter and early next year. This is also the reason why we are not pessimistic about U.S. stocks and have consistently indicated that the U.S. dollar may slightly strengthen in the fourth quarter (see "The U.S.-China Credit Cycle May Welcome Another Turning Point").

Chart: The U.S. fiscal pulse in 2025 will significantly decline due to a high base, and we estimate that it will turn positive to 0.5% in the fiscal year 2026.

![](https://mmbiz-qpic.wscn.net/sz_mmbiz_png/fzHRVN3sYs9XjJQdvYbJBKL1XSqibVywEsHk3nD1zB7QHWzeZrI1rfPltuO5F4XWSACpc6uZm3a8r45yicgNPViag/640? Data Source: Haver, CICC Research Department

Chart: Recent significant rebound in new and existing home sales in the United States

Data Source: Wind, CICC Research Department

From the current interest rate cut expectations reflected in various asset classes for the next year, the ranking is as follows: interest rate futures (2 times) > dot plot (1.5 times) > copper (1.3 times) > gold (1.2 times) > U.S. Treasuries (0.9 times) > S&P 500 (0.4 times) > Dow Jones (0.3 times) > Nasdaq (0.2 times). This indicates that most assets are more hawkish than the Federal Reserve's dot plot, especially U.S. stocks, which incorporate fewer rate cut expectations.

Chart: Current ranking of interest rate cut expectations reflected in various asset classes: interest rate futures (2 times) > dot plot (1.5 times) > copper (1.3 times) > gold (1.2 times) > U.S. Treasuries (0.9 times) > S&P 500 (0.4 times) > Dow Jones (0.3 times) > Nasdaq (0.2 times)

Data Source: Bloomberg, Federal Reserve, CICC Research Department

Specifically, 1) U.S. Treasuries: 3 rate cuts correspond to a long-end U.S. Treasury yield center of 3.8-4.0%. However, in the short term, we need to wait for the next rate cut expectations to heat up. After subsequent expectations are realized, rates may turn to rise, and it is recommended to shift to short-term bonds in allocation. 2) U.S. stocks are not pessimistic; structurally, cyclicals may catch up with technology. Although current U.S. stock valuations are relatively high, leading to volatility, continuous improvement in earnings is our main basis for not being pessimistic. The continuous new highs in U.S. stocks this year also confirm our judgment. The subsequent recovery of the U.S. credit cycle will provide more support (《 The Sino-U.S. Credit Cycle May Welcome Another Turning Point》), and structurally, traditional cyclicals may gradually catch up with technology. 3) The U.S. dollar is unlikely to weaken significantly, with a slight strengthening possible in the fourth quarter Under the baseline assumption of fundamental repair, the US dollar is unlikely to weaken significantly, and we continue to highlight the possibility of a slight strengthening in the fourth quarter. 4) The long-term narrative for gold remains intact and difficult to falsify, but this recent surge and subsequent pullback also fully demonstrate that its movements can be easily overdrawn, leading to significant volatility; therefore, dollar-cost averaging is a more suitable strategy.

Chart: Under the baseline scenario, the Federal Reserve still has room for 3 rate cuts, corresponding to a long-term bond yield center of 3.8~4%

Source: Bloomberg, China International Capital Corporation Research Department

Chart: Under fundamental repair, the US dollar is unlikely to weaken significantly, with a possibility of slight strengthening in the fourth quarter

Source: Haver, Bloomberg, China International Capital Corporation Research Department

Authors of this article: Liu Gang, Xiang Xinli, et al. Source of this article: CICC Insights, Original title: "CICC: The Federal Reserve's 'Next Step'"

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