When will the Fed cut interest rates?

Last year, I wrote an article saying that we should not easily bet on the Fed to cut interest rates soon, but should be wary of the Fed raising interest rates to some extent.

Since then, I have never written any articles about Fed policy speculation, because the market has been full of optimistic remarks about interest rate cuts, which is obviously contrary to my point of view.

However, the changes in market sentiment since then are also very interesting: from the initial optimism that interest rates will be cut soon (some said in December last year, some said in March this year...), to now basically no mention of interest rate cuts in the first half of the year.

The reason why market sentiment is so irrational, I once shared my views in a Twitter exchange at the beginning of the month: many articles and opinions on interest rate cuts in the market are irrational and emotional, and even some basic logic is very lacking.

I once said that the Fed's policy is not a "conspiracy" but an "open conspiracy", that is, unless a black swan flies out, it will act transparently according to the public rules it has set. Even if it wants to play "tricks", it will be "playing tricks" openly and openly, and will not play a show without a clue.

What is openness and transparency?

That is, he will share his views and ideas publicly. As for whether readers can read the "subtext" from it, it depends on their own ability.

And 99.99% of the articles on the market can't read the "subtext" at all, so they can only guess and bet.

Today, I will share with you a high-quality article that interprets the (future) intentions of the Federal Reserve (see the link at the end of the article).

This article interprets the speech "Some Thoughts on r*: Why Did It Fall and Will It Rise?" given by Christopher J. Waller, a member of the Federal Reserve Board, in Iceland on May 24. The full text is published on the official website of the Federal Reserve and anyone can see it.

At present, the US market generally believes that as long as Trump is not negatively affected by the lawsuit, the probability of winning the election at the end of the year is very high. If Trump is elected, the market believes that Waller is likely to take over from Powell as the next chairman of the Federal Reserve.

This speech is Waller's thinking on the current interest rate policy in the United States, which can help us peek into the possible direction of the Fed's future policy.

Before introducing the interpretation of this article, I would like to share two prerequisite knowledge points with you:

The relationship between Treasury yields, prices and face rates.

The difference in the governing philosophy between the Democratic and Republican parties in the United States.

I have written an article specifically about the relationship between Treasury yields, prices and face rates.

In general, the face rate of Treasury bonds is fixed. But once the Treasury bonds are issued and listed, their actual yield has little to do with the face rate, but is closely related to the trading price of the Treasury bonds. The higher the trading price, the lower the actual yield; the lower the trading price, the higher the actual yield.

But when the government issues new Treasury bonds, the face rate of the new Treasury bonds is closely related to the actual yield of the existing trading Treasury bonds. If the actual yield of existing treasury bonds is very high, it is meaningless to set the coupon rate of newly issued treasury bonds very low, because it is very likely that no one will buy them or they will be forced to issue them at a discount.

Therefore, if it is expected that the coupon rate of newly issued treasury bonds will be low and they will be issued smoothly, the actual yield of existing treasury bonds cannot be high. So how to regulate the actual yield of existing treasury bonds so that it is not too high? A very important market means is to reduce the supply of treasury bonds on the market, drive up their trading prices, and lower their actual yields.

Next, let's look at the differences between the Democratic and Republican parties in their governing philosophies:

The Democratic Party has always advocated a big government, that is, they believe that a big government has enough power to ensure fairness, help the weak, and maintain social stability and healthy development.

The Republican Party's philosophy is that the government only needs to do basic work such as maintaining order, supervision, legislation, and law enforcement, and leave other things to the market as much as possible. Let the market fully release its vitality and fully demonstrate its creativity. The direct consequence of the government being too powerful is that the public institutions become huge and the bureaucracy becomes inefficient, which eventually leads to the breeding of corruption and the abuse of power, causing the free market to be disturbed and unable to play its self-regulatory function.

The two parties' ideas are reflected in fiscal policy as follows:

The Democratic government needs to set up more institutions, hire more civil servants, manage more things, and intervene in more market operations, and all of this requires more money. The most direct way to get money is to issue more treasury bonds - that is, to increase the supply of treasury bonds. Its direct consequence is that the trading price of treasury bonds is forced to fall and the actual yield rate to rise.

The Republican government, on the contrary, hopes to cut unnecessary government agencies and civil servants as much as possible and reduce unnecessary government intervention, which naturally reduces government spending and makes it unnecessary to issue too many treasury bonds - that is, reduce the supply of treasury bonds, which makes the trading price of treasury bonds rise and the actual yield rate fall.

Of course, the above-listed situations are classic scenes under very ideal conditions. The current Democratic and Republican parties in the United States are no longer 100% classic. However, in some basic principles and policy concepts, the two parties still maintain a large difference, and the policies they formulate will also be significantly different.

Let's take a look at the analysis of Waller's speech in this article.

In the public statements of the Federal Reserve in recent years, it is often mentioned that the "neutral interest rate" should be controlled at a certain level.

What is the "neutral interest rate"?

Waller uses two indicators to measure: the actual yield rate of 10-year treasury bonds and US inflation-protected bonds.

This article draws the following conclusions through analysis of Waller’s speech:

“What Waller really wants to express is that the current neutral interest rate in the United States continues to rise, and the main reason is the rampant supply of treasury bonds. This actually explains from another perspective why the Federal Reserve has been reluctant to cut interest rates. In layman’s terms, since the neutral interest rate, which is a reasonable standard, is rising, it becomes unreasonable to lower the policy interest rate now. If you want to reasonably lower the policy interest rate, you must first lower the neutral interest rate, which is a reasonable standard. And the current neutral interest rate is pushed up by the continued excessive issuance of treasury bonds.”

“Or to put it more bluntly, what Waller wants to express is that as long as the left-wing Democratic Party is in power, treasury bonds will be issued excessively, the neutral interest rate will definitely rise, and the Federal Reserve will be reluctant to cut interest rates. Only when the right-wing Republican Party is in power can the treasury bonds be issued less, the neutral interest rate can be lowered, and the Federal Reserve can continue to cut interest rates cleanly and efficiently.”

This analysis reads out the “voiceover” of Waller’s speech.

Does this mean that the Fed will not cut interest rates before this year's election?

My understanding of this point is slightly different from that of this analysis article.

I don't think so. It just expresses the true views of the future Fed chairman on interest rates and the measures he prefers to take:

In order to cut interest rates cleanly, in addition to other policy measures, reducing the supply of national debt is probably also a very worthy operation to consider.

Then, we can carefully observe whether the US government will move in this direction.