Original Title: The Fed, Interest Rates, and the Economy: A Primer

Original Source: Binance Research
Original Translation: Deep Tide TechFlow

Introduction

In today's ever-changing global economic landscape, the monetary policy direction of the Federal Reserve sets the tone for the global financial markets. In September 2024, the Fed cut interest rates for the first time since 2020, initiating a new rate-cutting cycle.

Binance Research recently released a report that delves into the origins of the Fed's interest rate policy and its impact on the economy and various assets.

Starting from economic theory, the report combines latest data and historical experience to systematically analyze the relationship between interest rates, inflation, employment, and other core economic indicators. Additionally, it provides a comprehensive analysis of the performance of different asset classes such as stocks, bonds, commodities, and cryptocurrencies during a rate-cutting cycle, offering investors clear decision-making references.

Deep Tide TechFlow has summarized the key information from the report as follows.

Key Points

· Latest Rate-Cut Dynamics: The Federal Reserve announced a 0.5% rate cut in September 2024, followed by an additional 0.25% cut in November, marking the first rate cut action since the COVID-19 response measures in March 2020. The market expects further rate cuts of 1-2 percentage points in 2025, with a 62% probability of another 0.25% rate cut in December.

· Policy Background Analysis: The Federal Reserve adheres to a "dual mandate" principle, aiming to promote maximum employment and maintain price stability (with a 2% inflation target). In mid-2022, inflation briefly surpassed 9%, prompting the Fed to take aggressive rate hike measures, raising rates to the highest level in 20 years. As inflation gradually cools down, the Fed has initiated a new round of rate cuts.

· Interest Rate Transmission Mechanism: As the "price of money," interest rates affect the market through two main channels:

- Reducing borrowing costs, making it easier for market participants to access funds while lowering the burden of existing debts

- Lowering the risk-free interest rate, prompting investors to seek other investment channels to seek higher returns

· Historical Trend: The US interest rate has shown a structural downward trend over the past 50 years, from 8-10% in the 1980s to near-zero interest rates in the 2010s, and more recently to above 5%.

· Asset Performance Analysis:

- The stock market (S&P 500) generally experiences an upward trend after rate cuts, but there may be exceptions during economic recessions

- Commodities have a complex relationship with interest rates, influenced by factors such as inventory costs, yield volatility, and exchange rates

- Bond prices have a clear inverse relationship with interest rates

- Although cryptocurrency has limited historical data, it has shown strong performance during rate-cutting cycles, such as a 537% growth in the 12 months following the rate cut in March 2020

Policy Shift: The Global Central Bank Rate-Cutting Era Begins

On September 18, 2024, the Federal Reserve lowered the federal funds target rate range by 0.5 percentage points to 4.75-5.00%, marking its first rate cut since March 2020 in response to the COVID-19 pandemic. Prior to this, in response to rising inflation, the Fed aggressively raised rates from March 2022 to July 2023, then maintained rates unchanged in eight consecutive meetings until this rate cut. The November 0.25% rate cut further confirmed the onset of a new rate-cutting cycle.

The Fed's policy actions have always revolved around its dual mandate: promoting maximum employment and maintaining price stability. In the post-pandemic period, rapid price increases saw mid-2022 inflation briefly exceeding 9%, prompting the Fed to initiate its most aggressive rate-hiking cycle in 20 years, raising the target rate from 0-0.25% during the pandemic to 5.25-5.50%. As inflation gradually cools, the Fed has started shifting toward a more accommodative stance. The current market expects a 1-1.5 percentage point rate cut in 2025, with a 62% probability of a 0.25% rate cut in December (38% probability of no change).

The interplay between inflation, rate cuts, and the broader economic system (including asset performance) is intricate and warrants close attention from market participants.

It is worth noting that in 2024, several global central banks have embarked on a rate-cutting process, a trend that will have a profound impact on global financial markets.

Basic Concept: Interest Rate and Economic Mechanism

Warren Buffett once said, "Interest rates are the gravity of the financial universe." Let's start from the most basic concept to understand how interest rates affect the economic mechanism.

Basic Principle of Interest Rates

• Core Definition: Interest rate is fundamentally the "price of money"

Raising Interest Rates = Money becomes more expensive

Lowering Interest Rates = Money becomes cheaper

Two Major Impacts of the Current Rate Cut Environment

1. Debt and Lending Effect

· Businesses and institutions can obtain financing at a lower cost, promoting investment expansion

· The interest burden of existing debt is reduced, improving cash flow

· Consumer borrowing costs decrease, stimulating consumption and housing demand

· Overall economic activity is boosted, contributing to economic growth

2. Yield Effect

· The yield of risk-free assets such as government bonds decreases

· Investors are forced to seek other investment channels for higher returns

· Valuations of risky assets such as stocks and real estate receive support

· Funds shift from low-risk assets to high-risk assets

Key Economic Variables

1. Inflation

· The Federal Reserve has set 2% as the long-term inflation target

· It exceeded a high of 9% in mid-2022

2. Employment Situation

· The current unemployment rate is maintained at a relatively healthy level of 4.1%

· Non-farm payroll data is released on the first Friday of each month, a key market indicator

3. Market Environment and External Factors

· Corporate Earnings: Quarterly financial reports and expectations are a barometer of market confidence

· Regulatory Policy: Regulatory stance on financial innovation including cryptocurrency (as shown in the chart below, green represents a significant increase in crypto-friendly individuals in the U.S. House and Senate post-election)

· Geopolitics: External impacts such as international trade relations, regional conflicts, etc.

· Macroeconomic Indicators: Including trade balance, consumer confidence, PMI, etc.

Historical Perspective: Past Fed Rate Cut Cycles and Asset Performance

Interest Rate Trends

Over the past 50 years, U.S. interest rates have shown a structural downward trend:

· 1980s: Maintained at high levels of 8-10%

· 2010s: Near-zero interest rate levels

· Recent: Rose to above 5%

· September and November 2024: Initiation of a new rate cut cycle

Historical Performance of Various Assets

1. Stock Market (S&P 500)

· Overall Trend: Typically rises post-rate cuts

Specific Performance:

September 1984 First Rate Cut: 3 months +1%, 6 months +9%, 12 months +14%

July 1995 Rate Cut: 3 months +6%, 6 months +13%, 12 months +22%

Special Cases: Negative returns observed in 2001 and 2007 (during economic recessions)

January 2001: 12 months -12%

September 2007: 12 months -18%

2. Commodities

· Influencing Factors:

Inventory Cost: Interest Rates Impact Holding Costs

Yield Characteristics: No Fixed Income

USD Exchange Rate: Commodities Mostly Priced in USD

· Inflation Linkage:

- Typically Regarded as a Leading Indicator of Inflation

- Commonly Used as an Inflation Hedge Tool

3. Bonds

· Core Characteristic: Exhibits a Clear Inverse Relationship with Interest Rates

· Operational Mechanism:

- Interest Rate Increase → Bond Price Decrease

- Interest Rate Decrease → Bond Price Increase

Ten-Year Treasury Yield: Highly Correlated with the Federal Funds Rate

4. Cryptocurrency

· Historical Data: Only Experienced Two Rate Cut Cycles (Second Half of 2019 and March 2020)

· Performance Highlights:

July 2019 Rate Cut: 12-Month +25%

March 2020 Rate Cut: 12-Month +537%

· Special Considerations:

- Short Sample Period

- Relatively Small Market Size, High Volatility

- Influenced by Multiple Factors, Not Just Interest Rate Changes

This historical review shows that while rate cuts typically support asset prices, the specific performance varies by asset class and macro environment. Especially during an economic downturn, even rate cuts may not be able to prevent asset price declines, indicating that investors need to consider multiple factors comprehensively rather than making investment decisions solely based on rate cuts.

Conclusion: Global Rate Cut Cycle Initiated, Market Opportunities and Challenges Coexist

As the report shows, September 2024 became the fourth-largest rate cut month of the century, with 26 central banks globally implementing rate cut policies. This trend continued into October and November, marking the start of a new cycle in global monetary policy. As the most influential central bank globally, the Fed's two rate cuts in September and November not only had far-reaching impacts but also heralded the possibility of even broader policy easing in 2025.

From a historical perspective, a rate-cutting cycle often reduces the cost of money, improves the market's liquidity environment, and thereby provides support for asset prices. However, this rate-cutting cycle has its uniqueness: Global inflation has significantly fallen from its peak in 2022, but there is still a need to be vigilant against the risk of inflation rebound; the labor market remains relatively stable, with the unemployment rate staying at a healthy level of 4.1%; geopolitical tensions have added additional uncertainty.

Looking ahead to 2025, the market broadly expects the Fed to continue cutting rates by 1-1.5 percentage points. In this context, major central banks worldwide may follow the Fed's lead to further improve the liquidity environment. However, while investors seize opportunities, they also need to stay cautious: Different asset classes may perform differently during a rate-cutting cycle, and simply following the rate cuts may not achieve the desired returns. It is recommended that investors, with a full understanding of the fundamentals, focus on structural opportunities, make prudent allocations, to better cope with this new market environment.

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