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China-US Interest Rate Differential Draws Attention

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As the world economy continues to navigate through various challenges, the dynamics between major global economies like the United States and China have taken center stageThis week, the Federal Reserve is widely expected to announce another interest rate cut, likely by 25 basis points, in an effort to stimulate growthHowever, the path to similar measures in the future appears clouded by both domestic tax cuts and inflationary pressures arising from external tariffs and immigration policiesFinancial markets are left scrambling to interpret what the Federal Reserve's actions mean for future interest rate adjustments, particularly as we approach the year 2025.

In contrast, China's financial outlook seems more stable as it prepares for further reductions in reserve requirements and interest rates

Recent trends in bond yields suggest a sizeable cut of about 20 to 30 basis points may be on the horizonBy December 17, China's ten-year treasury bond yield fell to 1.72%, marking a significant decrease of nearly 50 basis points since late NovemberMeanwhile, the yield on equivalent US bonds has surged to 4.418%, widening the gap between the two nations to around 270 basis points—an unprecedented difference exceeding historical records.

According to reports from the esteemed Wall Street Journal reporter Nick Timiraos, expectations among investors seem to be skewed toward a more rapid pace of cuts by the FedHowever, within the walls of the central bank, discussions hint at a pause in such actions if the economy maintains its current momentum

This divergence in outlook has resulted in considerable uncertainty in markets, prompting analysts to revise their predictions dramatically since the Fed initiated its latest round of cuts in September, when projections for a 130 basis point reduction in 2025 were on the tableNow, current estimates barely hold up to 50 basis points.

Given this shifting landscape, Fed Chair Jerome Powell's upcoming press conference is poised to be a significant eventAnalysts speculate that a plausible strategy could involve signaling a halt to further rate decreases in the immediate futureThe Fed officials’ previous forecast of four potential cuts in the coming year may now face revisions that reduce this number by one or two.

Within recent discussions, Fed officials remarked that the anticipated cut may mark a critical juncture, suggesting a possible halt in aggressive easing measures until inflation trends closer to their target rate

Those in the financial community await such signals with great anticipation, given the prominence of inflation and employment figures in shaping monetary policy.

Cleveland Fed President Beth Hammack emphasized the necessity to slow down the reduction pace, reflecting on similar historical precedents from the 1990sConcurrently, Timiraos points out that the Fed's recent communications are likely to convey a more cautious outlook and that the quarterly rate projections may underscore the growing uncertainty regarding future cuts.

A crucial factor in these predictions includes the so-called neutral interest rate, which does not stimulate nor suppress economic activity

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This rate is believed to fall between 3% and 3.25%, indicating an estimate of around 130 basis points of possible cutsHowever, assessing the actual level of this neutral rate is fraught with complications and discrepancies among economistsIf the Fed gets closer to this neutral ground, further cuts may simply lack justification.

The criteria dictating the decision to lower interest rates hinge on inflation and employment metricsInflation in the United States slightly increased to 2.7% in November from 2.6% the previous month, while the job market saw the addition of 227,000 non-farm jobs, outperforming expectationsThese figures indicate that even if the Fed opts for another quarter-point reduction, it will likely remain above most estimates of the neutral rate.

Concerns also linger among Fed officials about continuing cuts amid a surge in asset prices such as stocks and cryptocurrencies that may stimulate spending and impede progress toward lowering inflation rates.

The impact of certain policies on economic growth and inflation

Kristina Hooper, Chief Global Market Strategist at Invesco, recently articulated four key policies with the potential to significantly influence the US economy.

First is the deregulation agenda

A political shift in favor of less regulation can invigorate corporate investment and consequently bolster economic growth while contributing to heightened inflation ratesSectors like finance and cryptocurrencies are particularly likely to benefit from relaxed regulations.

Secondly, anticipated tax cuts would likely propel optimism, fostering continued market momentum in the short termThis creates a potential environment ripe for risk-seeking investments, reinforcing inflationary tendenciesReal Estate Investment Trusts (REITs) could stand to gain, especially if provisions in the Tax Cuts and Jobs Act aimed at reducing taxes for specific entities are extended.

Next on the agenda are tariff policies, which currently command significant attention

Hooper noted that tariffs may raise inflation in the short term, but prolonged implementations might suppress overall consumer demand.

Finally, contrasting with tariffs, restrictive immigration policies are perceived to pose greater inflationary risks for the US, as high service sector costs have historically been a primary contributor to inflationDavid Seif, Chief Economist at Nomura, elaborated that if there were aggressive efforts to expel a million illegitimate immigrants, inflation might rise substantially, particularly considering the current tight labor market.

In a more extreme scenario, if such expulsion efforts raised inflation sufficiently to prompt the Fed to pause or even reverse its easing policies, stock market returns could decline

Should significant economic damages result from these actions alongside increased inflation, a stagflation scenario could ensue, drastically affecting stock prices.

However, this is not the prevailing view on Wall Street, where consensus forecasts indicate the Fed may cut rates two to three times during 2025.

The persistent gap between China and US interest rates

China's prospects for interest rate cuts appear significantly more reliable

A recent work meeting articulated the need to implement a moderately easing monetary policy, signaling potential cuts to reserve requirements and interest rates while maintaining adequate liquidityLianganping, Chief Economist at Guotai Junan Securities, estimates rates might drop by 30 to 50 basis points over the next year, with the one-year and five-year Loan Prime Rates (LPR) potentially decreasing by 30 and 60 basis points, respectively.

Moreover, Nomura suggests the People's Bank of China will likely lower interest rates 15 basis points in both the first and second quarters next yearBy this estimate, rates could fall to 1.2%, 2.8%, and 3.3% for the seven-day reverse repurchase rate, one-year LPR, and five-year LPRCurrent market sentiment indicates a swift response from bond markets, making significant short-term yield drops less likely.

Recent trends have prompted some institutions to pocket gains, anticipating limited room for further drastic drops in yields, with ten-year treasury bonds already flirting with the 1.8% threshold.

That said, many analysts still recognize looming opportunities within China's bond market, predicting long-term yields for ten-year bonds might stabilize between 1.5% and 1.8% by 2025.

Dan Kun, Fixed Income Director at Schroders in China, remarked on what he terms an “asset shortage” in the bond market, suggesting that while the momentum has thus far decreased future return expectations, critical factors impacting market stability are yet to appear—such as shifts in monetary policy and resurging inflation expectations

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