Don't underestimate Trump's determination: How will the US "cut interest rates"?

The market generally expects that a Federal Reserve rate cut will suppress short-term interest rates, while long-term yields will face upward pressure due to inflation concerns.

Written by: Li Xiaoyin

Source: Wallstreetcn

The Federal Reserve's monetary policy meeting will be held this month, and the current market focus is on whether the Fed's independence will be compromised and whether the upcoming rate cut will have a "political" undertone.

Recently, Peter Tchir, Head of Macro Strategy at Academy Securities, wrote that such concerns have fueled a widespread expectation: even if the Fed initiates rate cuts, it will only suppress short-term rates, while long-term yields will face upward pressure due to inflation worries. Currently, this view has become mainstream in the market and is guiding the positioning of many investors.

However, Tchir believes that investors may not be thinking "outside the box" enough and are underestimating the government's plans to suppress interest rates. In addition to traditional monetary policy, the U.S. government may adopt a series of unconventional measures, including adjusting the Fed's balance sheet, changing the way inflation data is calculated, or even revaluing gold reserves to achieve its goal of lowering long-term rates.

Tchir adds that these potential policy options go beyond simple rate cuts and may involve coordinated actions between the Fed, the Treasury, and even accounting standards.

"Political" Rate Cuts or Data-Driven Rate Cuts?

Market concerns about "political" rate cuts may overlook the economic rationale for rate cuts themselves.

The article states that if there is sufficient data-based justification for significant rate cuts, the market's panic over long-term rates may not materialize.

Tchir points out that signs of economic weakness appeared even before officials began to disagree on rate cuts. For example, at the July Fed meeting, two officials dissented on the decision not to cut rates, and subsequently released June employment data was significantly revised downward; Powell's speech at Jackson Hole also showed a dovish stance.

These signs suggest that the reasons for supporting rate cuts within the Fed may be more sufficient than what the meeting minutes reveal.

Tchir believes that if subsequent employment data fails to show strong improvement, a 50 basis point rate cut in September would be entirely "reasonable" and should not be simply viewed as politically driven. If the rate cut is seen by the market as justified, the anticipated "alarm"—that is, a sell-off in long-term bonds—would be unlikely to occur.

The Effectiveness of Traditional Rate Tools Is Weakening

Tchir believes that another reason the U.S. government is considering unconventional options is that the effectiveness of traditional monetary policy tools is weakening.

The article explains that influencing the economy solely by adjusting the front-end federal funds rate involves a "long and variable" lag in transmission, making the effect difficult to assess. During the months it takes for policy to take effect, any factors such as trade wars or geopolitical conflicts could alter the economic trajectory.

In addition, since the era of zero interest rate policy, many corporations, individuals, and municipal bond issuers have locked in long-term low rates, making them much less sensitive to changes in short-term rates. This means that the effectiveness of transmitting monetary policy through short-term rates is no longer what it used to be.

What Might Be in the "Toolbox" of Unconventional Policies?

If traditional tools are not effective, the government may open its "toolbox" of unconventional policies to directly intervene in long-term rates.

Aggressive Rate Cuts with Forward Guidance

One possible strategy is to "go all in at once." For example, a one-time sharp rate cut of 100 basis points, while promising to keep rates unchanged for the next several quarters unless there is a significant change in the data.

This move aims to quickly dispel market speculation about the future path of rate cuts. A one-time 100 basis point rate cut would require the yield curve to steepen dramatically for the 10-year U.S. Treasury yield to remain above 4%, which could be a difficult task for "bond vigilantes."

Attacking Inflation from the Data Side

Another strategy is to directly challenge the validity of inflation data. Currently, the housing cost component, which has a huge weight in the U.S. CPI, is artificially inflating inflation data due to its lagging "owner's equivalent rent" (OER) algorithm.

Tchir points out that new indicators compiled by the Cleveland Fed show that real rent inflation has fallen back to normal levels, far below the housing inflation in the CPI. By emphasizing such data differences, the U.S. government can effectively weaken market fears of inflation and clear the way for rate cuts.

Restarting "Operation Twist"

The core measure may be to restart "Operation Twist" (OT), by simultaneously selling short-term Treasuries and buying long-term Treasuries to suppress long-term rates.

Currently, the Fed's balance sheet is heavily weighted toward short-term debt, holding about $2 trillion in bonds with maturities of 7 years or less, while bonds with maturities of 15 years or more amount to only $1 trillion. Analysts envision that the Fed could sell about $1.2 trillion in bonds with maturities of 3 years or less and use the proceeds to buy long-term bonds of 20 years or more.

Tchir points out that this move would nearly double the Fed's holdings in the ultra-long bond market, giving it enough purchasing power to influence or even control about 50% of the free float in the ultra-long bond market, thereby directly suppressing long-term yields.

Other Potential Options

Other more disruptive options may also be considered.

For example, yield curve control (YCC), although unprecedented in the U.S., has been practiced in Japan. For a government accustomed to "setting prices" through tariffs, setting a cap on yields is not unimaginable.

In addition, revaluing U.S. gold reserves is also an option. According to estimates, revaluing U.S. official gold reserves at market prices could generate about $500 billion in accounting gains. Although this move is complex, it can effectively divert market attention and may provide funding for other investment plans.

Tchir adds that this move could lead to a weaker dollar, but for a government aiming to improve the trade deficit, this may be "a feature, not a bug."