The upcoming decision by the Federal Reserve, expected on Thursday morning, is anticipated to result in a 25 basis point rate cutYet, the future implications of domestic tax cuts, external tariffs, and immigration policies cast uncertainty over the path of interest rate reductions leading up to 2025. Unlike the U.S., China’s outlook appears more certain regarding further cuts in reserve requirements and interest ratesRecent trends in bond yields suggest a potential drop of about 20 to 30 basis points may be in the offing.

As of December 17, China’s 10-year government bond yield recorded a sharp decline, settling at 1.72%, a significant fall from nearly 50 basis points since November 29. In stark contrast, U.S10-year Treasury yields soared to 4.418% within the same timeframe, further widening the yield gap between the two countries to a striking 270 basis points, exceeding the historical maximum of 250 basis points recorded back in 2002. This shift in yield spreads has garnered attention regarding its ramifications on market dynamics.

The speculation surrounding the Federal Reserve’s interest rate reduction frequency suggests a possible decrease in the number of rate cuts next year

Recently, Nick Timiraos, a journalist often referred to as a conduit for the Federal Reserve's communications, indicated that while investors hold strong beliefs regarding an imminent rate cut, the economic stability reflected within the Fed could produce a different sentiment internally, making the rationale for further cuts less convincing.

This shifting narrative has introduced greater confusion within the marketAs Eric Robertsen, Chief Strategist at Standard Chartered, remarked, when the Fed initiated its current cycle of reductions on September 18 with a 50 basis point cut, the market was pricing in a total of about 130 basis points of cuts by 2025. Currently, the projection has plummeted to under 50 basis points, demonstrating how swiftly these expectations can pivot.

Consequently, the manner in which Jerome Powell will communicate future guidance during the accompanying press conference to the rate decision is highly scrutinized

• China's Chip Industry Sees Progress
• The Logic Behind Global Commodity Pricing
• Guoxuan Deal Adds $1.2 Billion to Volkswagen Profit
• Dow Jones Posts Nine-Day Losing Streak
• Argentina's GDP Up Quarter-on-Quarter, Down Year-on-Year

There’s a prevailing opinion that the most prudent approach for the Fed would be to downplay immediate future cuts, possibly hinting that the upcoming meetings may not consolidate further reductionsAlthough officials previously anticipated four rate cuts for the following year, these forecasts may now trend downwards by one or two cuts.

Some Fed officials recently interpreted the forthcoming rate cut as marking the conclusion of the initial phase of reductionsIn this first stage, higher borrowing costs regulated the cuts, and the threshold for such reductions was relatively modestThis has been compounded by a prolonged duration of observing that inflation approaches their target and shows signs of decreasing.

Earlier this month, Cleveland Fed’s Beth Hammack suggested that the current timing is approaching an optimal period to slow down the pace of rate cutsDrawing historical parallels to the 1990s, when the Fed made rapid cuts totaling 0.75 percentage points followed by a pause, Hammack's insights reflect a cautious stance moving forward.

Timiraos articulated that the Fed seems poised to embrace a more conservative outlook at the upcoming press conference, indicative of anticipation surrounding the uncertainty of further rate cuts reflected within quarterly predictions

The concept of a neutral rate, which neither stimulates nor constrains economic activity, has recently been pegged between 3% and 3.25%. This perception once led the market to believe that the Fed had ample room for further reductions of about 130 basis pointsHowever, determining the precise level of this rate remains complex, with economists expressing diverse opinionsAs the Fed nears this neutral rate, should inflation stabilize and the labor market display strength, the rationale for more cuts may diminish.

The key metrics for gauging the decision to cut rates hinge upon inflation and employment statisticsFor instance, in November, U.Sinflation slightly rose from 2.6% in October to 2.7%, slightly above the Fed’s 2% targetFurthermore, the U.Snon-farm payrolls for November recorded an increase of 227,000 jobs, surpassing the anticipated 220,000, alongside wage growth demonstrating year-on-year and month-on-month increases of 4% and 0.4%, respectively.

In essence, the Fed appears to have sufficient justification to temper the pace of rate cuts, even if reduction by an additional 25 basis points maintains an interest level above most estimates of neutral rates, pegged roughly between 2.5% and 4%. The current federal funds rate hovers around 4.6%.

Moreover, some officials express concerns regarding the implications of continued rate cuts amidst rapid asset price inflation, such as in stocks and cryptocurrencies

Donald Kohn, a Fed veteran, raised a critical question: does additional easing exacerbate existing inflation pressures? “Are we essentially adding fuel to the fire? I’m unsure whether that’s the correct approach,” Kohn commented.

When discussing policies with the most substantial potential impact on growth and inflation, Kristina Hooper, Chief Global Market Strategist at Invesco, identified four areas of particular influence.

The first is deregulationWhen the political winds favor a reduction in regulatory burdens, businesses are likely to expand investment, potentially nudging economic growth and, subsequently, inflation upwardsFinancial sectors and cryptocurrencies are poised to benefit immensely from such shifts.

The second crucial policy is tax reductionAnalysts predict the inevitability of tax cuts triggering a wave of optimism that could provide a temporary uplift to the U.S

economy, fostering a risk-seeking investment environment with inflationary tendenciesReal Estate Investment Trusts (REITs) are expected to capitalize on these developmentsIf the provision for a 20% tax decrease on specific “pass-through entities” extends, REIT shareholders could avail themselves of a deduction on their tax liabilities.

Thirdly, tariff policies garner significant attention in the contemporary economic climateHooper noted that tariffs could briefly inflate pricing, but prolonged implementation might dampen overall demand.

Finally, relative to tariffs, some argue that stringent immigration policies could put more upward pressure on U.SinflationThe soaring costs within the service sector have historically underpinned inflationary trends in the U.SDavid Seif, Chief Economist at Nomura, remarked, “If a drastic increase in deportations occurred, the resulting tightening of the labor market could easily ignite inflation spikes, particularly since the U.S

labor market is already quite strained.” Under general conditions, the U.Ssees roughly 250,000 to 4 million failed deportation cases annually.

“In an extreme hypothetical scenario, if high deportation rates lead to elevated inflation and prompt the Fed to halt or even reverse its easing policies, that could dampen stock market returnsIf labor market constraints negatively impact economic growth, leading to stagflation, stock markets could witness significant declines,” Seif warned.

That said, this outlook remains a minority sentiment on Wall Street, where most anticipate the Fed might deliver 2 to 3 cuts in 2025.

On the other hand, the near-term outlook for interest rate spreads between China and the U.Sappears unlikely to narrowThe Central Economic Work Conference on December 12 mandated a commitment to “implement a moderately accommodative monetary policy, timely rate cuts, and maintain ample liquidity.” Experts like Lian Ping, Chief Economist at Guangwu, mentioned that while lowered rates are on the table, they may not be substantial due to both internal and external pressure factors

He projected a cut of 30 to 50 basis points in the central bank’s policy rates in 2024, along with reductions of 30 and 60 basis points for the one-year and five-year Loan Prime Rates (LPR), placing market rates at historical lows.

Nomura holds a similar view, anticipating the central bank will lower rates by 15 basis points in both Q1 and Q2, bringing the 7-day reverse repurchase rate, one-year LPR, and five-year LPR to 1.2%, 2.8%, and 3.3%, respectivelyAdditionally, they expect the one-year Medium-term Lending Facility (MLF) rate to tighten to 1.7%.

Due to a swift reaction from the bond market, several institutions are already taking profits, indicating limited potential for drastic yield declinesWang Qiang, head of the research department at Nanyin Wealth Management, pointed out that recent rapid declines in bond rates have already projected a 20+ basis point cutting space, with 10-year bonds often breaking the 1.8% threshold and 30-year bonds exceeding 2%, suggesting that these shifts are well accounted for in the current pricing.

Though recent market indicators suggest improvements and a forthcoming return to a balance within bond markets, the probability of dramatic rate falls has decreased

It is projected that long-term bonds may be positioned for partial profit-taking, and adjustments can present reallocation opportunities.

However, in the intermediate to long term, institutional forecasts indicate potential positioning in the bond market, with consensus estimates for 10-year government bonds hovering between 1.5% and 1.8% by 2025.

Shroder’s Director of Fixed Income in China, Dan Kun, observed an “asset shortage” within the bond market, noting that the market may have already overextended expected yields“Despite existing downward trends, we are still witnessing transformations in the bond market poised for turnarounds, particularly surrounding shifts in monetary policy and new inflationary expectations,” said Kun“Ultimately, we maintain faith that bonds remain an essential foundation for household asset allocation.”