Source: Miaotou APP

The "hawkish interest rate cut" is here.

In the early morning of December 19, 2024, the Federal Reserve announced an interest rate cut of 25 basis points, lowering the target range of the federal funds rate from 4.5%-4.75% to 4.25%-4.5%. This is also the third consecutive interest rate cut by the Federal Reserve after September and November, with the cumulative rate of reductions throughout the year reaching 100 basis points.

Although the rate cut was in line with market expectations, Federal Reserve Chairman Powell's "hawkish" remarks made the market "ice and fire."

Powell pointed out that the FOMC statement added new language about "the extent and timing of adjusting interest rates," which means that the Fed is or will soon slow down the pace of interest rate cuts. The updated Fed dot plot shows that among the 19 FOMC members, 10 support two interest rate cuts next year, and the other three support one or three rate cuts. In September, the market generally expected the Federal Reserve to cut interest rates four times in 2025.

This "hawkish interest rate cut" triggered violent market fluctuations. The three major U.S. stock indexes plunged across the board. As of the close, the Dow, S&P and Nasdaq fell 2.58%, 2.95% and 3.56% respectively. Precious metal prices plummeted, with spot gold falling 2%. At the same time, the U.S. dollar index rose sharply, once reaching a peak. to 108.28, setting a new high in 2023; the 10-year U.S. Treasury yield also rose in the short term.

Looking back on Powell's leadership over the past four years or so, he has skillfully used words and signals to not only successfully guide market expectations, but also effectively reduce market uncertainty and violent fluctuations. He can be called a "master of expectation management." Therefore, his remarks are more about guiding market expectations rather than making final decisions.

Based on the following analysis, we believe that Powell’s drama will not last long, and the Federal Reserve will most likely continue to implement loose money, which will provide greater operating space for our country’s currency and provide A-shares with The market brings positive benefits.

On December 9, the Central Bureau meeting sounded the economic clarion call for 2025, clearly proposing that a more active fiscal policy and moderately loose monetary policy would be implemented. The expression "moderately loose money" has reappeared in high-level documents after 12 years. This is no small matter, and means that the tone is undergoing an important change.

This change requires the support of the Federal Reserve’s loose money.

But the question is, why do we think Powell has to cut rates? The answer to all this needs to be found in the current high debt levels and increasingly severe fiscal deficit problems in the United States.

There is a serious problem with the current financial situation of the United States - borrowing new debt to repay old debt. Simply put, issuing new bonds to repay the principal of maturing old bonds is essentially similar to a "Ponzi scheme." While this approach can keep the finances afloat in the short term, this debt-reliant model is extremely unstable in the long term.

If the Fed chooses not to cut interest rates or even raise interest rates,The U.S. fiscal deficit will further worsen, which will not only increase the country's debt burden, but may also put tremendous pressure on the stability of the U.S. economy, ultimately triggering a series of chain reactions.

Since the 1980s, the amount of debt in the United States has continued to soar. In 1990, the total debt of the United States was approximately US$3.2 trillion, which increased to US$5.62 trillion in 2000, and further exceeded US$13.5 trillion in 2010. Entering 2020, the total debt has reached US$27.7 trillion, and in 2023 it will exceed US$34 trillion. As of December 17, 2024, the total U.S. federal debt reached US$36.19 trillion, exceeding the US$36 trillion mark and setting a record high.

The U.S. debt is piling up. The main culprit is the fragmentation of the U.S. party system, especially the fiscal game between the two parties.

The American party system is based on a two-party system, mainly competition and cooperation between the Democratic Party and the Republican Party. Since the two political parties have large differences in their concepts and priorities in economic, social and fiscal management, their fiscal games often affect the efficiency and consistency of decision-making.

The game between the two parties often leads to short-term solutions to fiscal problems by increasing debt, while lacking long-term fiscal reforms and deficit control measures. This situation exacerbates the expansion of US debt and may ultimately affect the country's fiscal sustainability.

The process of accelerated debt expansion is not new, but the problem is that if market interest rates rise or the Federal Reserve raises interest rates, the interest rates on new debt will be higher than before. As of the end of September 2024, the weighted average interest rate on outstanding U.S. federal debt was 3.32%, about the highest level in 15 years.

For example, especially after the epidemic, interest rates in the United States were at historical lows at the end of 2021, and the yield on the 10-year Treasury bond was about 1.5%. Low interest rates allow the United States to issue new debt at low cost and easily cope with rolling debt. But entering 2023, as the Federal Reserve raises interest rates, the yield on the 10-year Treasury note soars to 3.5% or higher. The interest cost of new debt will rise accordingly, which means that we are facing heavier debt repayment pressure.

The consequences of this situation are increased expenditures, debt rollover and interest payment burdens, while fiscal revenue continues to decline due to the economic recession and the implementation of a series of tax cuts. This contradictory situation has led to the continued expansion of fiscal deficits.

In order to make up for this deficit, the only choice is to fill the fiscal gap by issuing debt, and these new debts bring higher interest payments, which makes the United States fall into a "vicious cycle of debt", and ultimately You may fall into the dilemma of "never being able to repay."

The question is, since the U.S. dollar is the global reserve currency, why doesn’t the United States directly print money to solve its debt?

The main financing methods in the United States include the issuance of treasury bonds, additional issuance of U.S. dollars and tax revenue. Why is the United States more inclined toWhat about issuing debt instead of directly printing money to finance it? There are two main reasons:

On the one hand, the currency issuance in the United States is the responsibility of the Federal Reserve and is not directly controlled by the United States.

The currency of the United States is responsible for the Federal Reserve, while finance (such as taxes, expenditures, etc.) is determined by the United States (through Congress and the President). Although the Fed's chairman is nominated by the president and confirmed by the Senate, the Fed operates completely independently of the day-to-day control of the president and Congress.

The United States does not have the power to directly intervene in the Federal Reserve, which means that the Federal Reserve usually does not directly choose to cut interest rates or print money due to high financial pressure, because the Federal Reserve’s monetary goals are mainly to achieve price stability (controlling inflation) and Maximizing employment rather than responding directly to fiscal pressures.

However, if the U.S. fiscal situation worsens, it may cause economic slowdown and financial market volatility, which will indirectly affect the Fed's policy.

On the other hand, printing money is not a "panacea", but a double-edged sword that may put the United States into deeper trouble.

As the world currency, the U.S. dollar has given the United States a powerful "minting privilege." Thanks to the global demand for the U.S. dollar, the United States can not only easily finance but also purchase almost all the world's goods through the U.S. dollar - after all, 60% of global foreign exchange reserves and 40% of global trade settlements rely on the U.S. dollar.

However, this does not mean that the Federal Reserve can "print money" at will - the widespread circulation of U.S. dollars does not equate to unlimited currency over-issuance. If the Federal Reserve prints excessive money, the new dollars will eventually flow back to the United States, which will inevitably increase the money supply and push up inflation.

This kind of inflationary pressure will cause the dollar to depreciate, and may even turn the dollar into "waste paper", accelerating the process of "de-dollarization" worldwide.

At the same time, as more dollars are on the market, investors' concerns about risks will also intensify. To combat inflation, investors will demand higher returns, which means future U.S. debt issuances will face higher interest rates. The increase in debt interest burden will not only fail to alleviate the financial difficulties of the United States, but will make the debt problem more serious and enter a "vicious cycle."

So, although printing money can avoid high interest burdens in the short term, it will lead to currency depreciation and economic instability in the long term, while bond issuance can raise funds from the international market at low cost. Countries around the world commonly use the U.S. dollar in international trade, and many governments and companies hold the U.S. dollar as a reserve currency, which provides the United States with the advantage of low-cost financing, especially through the issuance of U.S. Treasury bonds.

However, it is worth noting that although over-reliance on debt financing can temporarily alleviate short-term funding needs, in the long run, this "borrow more money" strategy will undoubtedly exacerbate the fiscal crisis. On the one hand, we need to face a growing debt burden, and on the other hand, we have to rely on debt financing. This situation may lead to increasingly serious financial problems.

If the Fed does not lower interest rates or even raises them, it may cause the U.S. fiscalThe worsening deficit may ultimately affect the stability of the U.S. economy and lead to a decline in global trust in the U.S. dollar, and the U.S. may even face fiscal bankruptcy.

To break this vicious cycle, there are theoretically two ways out: increasing federal revenue or reducing fiscal spending. However, in reality, the implementation of both is full of difficulties - Trump's tax cuts will further reduce revenue, and considering the global military strategic position and pressure of the United States, defense budget cuts are almost impossible.

In this case, the Federal Reserve may choose to cut interest rates to reduce the debt burden. Although interest rate cuts cannot fundamentally solve the debt problem, it can indeed temporarily relieve some of the pressure on interest payments and give more time to deal with the huge debt burden.

But the impact of the interest rate cut goes far beyond that. It is actually highly consistent with Trump’s “America First” policy. One of Trump's core goals is to promote the reshoring of manufacturing. He hopes to improve the competitiveness of domestic production in the United States, especially in terms of price, through tax cuts, deregulation and other measures. Cutting interest rates will cause the U.S. dollar to weaken, making U.S. goods cheaper in the international market, thereby improving the global competitiveness of U.S. manufacturers.

Of course, new problems brought about by interest rate cuts will also arise.

The biggest motivation for global investors, including central banks and institutional investors, to purchase U.S. bonds is based on the “gold credit” of the U.S. dollar and the fiscal endorsement of the United States. However, as the U.S. fiscal deficit continues to expand, the risk premium on U.S. debt has begun to rise. That is, investors may demand higher returns (i.e., interest rates) to compensate for the possible risk.

At this time, if the U.S. debt interest rate does not rise but falls, the attractiveness of U.S. debt will be greatly reduced, which may greatly reduce investors’ demand for U.S. debt, especially as the credit of the U.S. dollar gradually declines. Against this background, the willingness to buy U.S. debt will further weaken.

In fact, many holders of U.S. debt have begun to reduce their holdings. After 2022, the top six countries that have reduced their holdings of U.S. debt include China, Japan, Poland, Vietnam, Iraq and the Czech Republic. These companies once purchased U.S. bonds through trade surpluses to provide financial support for the U.S. economy. Now this "capital chain" is gradually breaking.

(Picture source: Huayuan Securities)

In this case , the Federal Reserve was forced to purchase "unsellable" government bonds, which directly led to the expansion of its balance sheet. This is a typical "balance sheet expansion" behavior. Since the outbreak of the epidemic, the Federal Reserve has rapidly increased its asset purchases in the face of economic shocks, leading to a sharp expansion of its balance sheet in the short term. As of early 2024, the total size of the Fed's balance sheet has reached approximately $8.5 trillion.

The Federal Reserve's continued "balance sheet expansion" has increased market liquidity. If the economy recovers, consumer confidence rebounds, and market demand picks up, excess money supply may eventuallyCause high inflation. Trump may increase production costs by increasing tariffs and implementing tough immigration measures, which will further intensify inflationary pressure. This situation will obviously increase the pressure on the Federal Reserve to continue lowering interest rates.

The Federal Reserve is in a dilemma - although interest rate cuts can alleviate debt pressure, under the trend of "de-dollarization", low interest rates will further weaken the attractiveness of U.S. debt, forcing new debt to rely on the Fed's balance sheet expansion , which may trigger high inflation; while raising interest rates will help maintain the operation of the "borrowing new debt for old debt" model, this will increase the risk of US fiscal collapse and even affect the overall economy.

But it’s the lesser of two evils.

As we mentioned before, although the risks of economic confrontation between China and the United States are accumulating, this confrontation does not have an upper limit, but has certain boundaries and constraints. Once this limit is broken, the Fed will face The situation will become more severe. Therefore, high inflation may not break out as expected.

All in all, the Fed has almost no choice but to embark on the path of continuous interest rate cuts, and Powell's "expectation management" will not work for a long time. This is not only an inevitable choice for the United States, but also provides greater operating space for our currency. At the same time, this once again supports our previous view - from a long-term perspective, the US dollar is down and gold is up.