Source: MiaoTou APP
“Hawkish rate cut” is here.
In the early morning of December 19, 2024, the Federal Reserve announced a 25 basis point cut in the target range for the federal funds rate from 4.5%-4.75% to 4.25%-4.5%. This is also the third consecutive rate cut by the Federal Reserve following September and November, with a total cumulative rate cut of 100 basis points for the year.
Despite the expected interest rate cut, Federal Reserve Chairman Powell’s ‘hawkish’ remarks have left the market in a state of contradiction.
Powell noted that the FOMC statement added language about “adjusting the magnitude and timing of rate cuts”, which means that the Federal Reserve is either slowing down or about to slow down the pace of interest rate cuts. The updated Fed dot plot shows that out of the 19 FOMC members, 10 support two rate cuts next year, while another 3 support one or three rate cuts. In September, the market generally expected the Fed to cut rates four times in 2025.
The ‘hawkish rate cut’ this time caused a violent market fluctuation. The three major U.S. stock indexes all fell sharply, with the Dow, S&P, and Nasdaq falling by 2.58%, 2.95%, and 3.56% respectively at the close; precious metal prices plummeted, with spot gold dropping by 2%; at the same time, the U.S. dollar index sharply rose, briefly reaching 108.28, hitting a new high in 2023; the yield on 10-year U.S. Treasury bonds also rose in the short term.
Looking back at Powell’s leadership over the past four years, he has skillfully used words and policy signals to not only guide market expectations successfully but also effectively reduce market uncertainty and volatility, making him a “master of expectation management.” Therefore, his remarks are more about guiding market expectations rather than making final decisions.
Based on the upcoming analysis, we believe that the drama of Powell will not last long. The Federal Reserve is highly likely to continue implementing loose monetary policies, which will provide greater operational space for our monetary policy and bring positive benefits to the A-share market.
On December 9th, the Political Bureau of the CPC Central Committee sounded the horn for the economic policy of 2025, clearly stating that a more proactive fiscal policy and moderately loose monetary policy will be implemented. The term ‘moderately loose monetary policy’ has reappeared in high-level documents after 12 years, which is not a small matter and indicates that there is an important shift in policy stance.
And this transformation requires the support of the Federal Reserve’s loose monetary policy.
But the question is, why do we think Powell has to cut interest rates? All of this still needs to be found in the current high level of debt and increasingly severe fiscal deficit in the United States.
#01 Paying off old debts with new debts
The current financial situation in the United States has a serious problem - borrowing new debt to repay old debt. Simply put, the government issues new bonds to repay the principal of expiring old debts, which is essentially similar to a Ponzi scheme. Although this approach can maintain financial operations in the short term, in the long run, this debt-dependent model is extremely unstable.
If the Fed chooses not to cut interest rates or even raise them, the US fiscal deficit will worsen, which will not only increase the government’s debt burden, but may also pose significant pressure on the stability of the US economy, ultimately triggering a series of chain reactions.
Since the 1980s, the scale of US debt has been soaring. In 1990, the total US government debt was about $3.2 trillion, which increased to $5.62 trillion in 2000 and further surpassed $13.5 trillion in 2010. By 2020, the total debt had reached $27.7 trillion, and by 2023, it exceeded $34 trillion. As of December 17, 2024, the total federal government debt of the United States reached $36.19 trillion, surpassing the $36 trillion mark and reaching a new historical high.
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The U.S. debt is piling up, and the main culprit is the division of the U.S. political system, especially the fiscal policy game between the two parties.
The political system of the United States is based on a two-party system, primarily the competition and cooperation between the Democratic Party and the Republican Party. Due to significant differences in their ideas and priorities regarding economic policy, social policy, and fiscal management, the game between these two parties in fiscal policy often affects the efficiency and consistency of decision-making.
The game between the two parties often leads to the short-term solution of fiscal problems by increasing debt, while lacking long-term fiscal reform and deficit control measures. This situation has exacerbated the expansion of U.S. debt, which may ultimately affect the country’s fiscal sustainability.
The process of accelerating debt expansion is not new in itself, but the problem is that if market interest rates rise or the Fed raises interest rates, the government’s interest on new debt will be higher than ever. As of the end of September 2024, the weighted average interest rate on outstanding U.S. federal debt was 3.32%, the highest level in about 15 years.
For example, especially after the epidemic, the interest rates in the United States were at a historical low by the end of 2021, with a yield of about 1.5% for 10-year Treasury bonds. The low interest rates allowed the US government to issue new debt at a low cost, easily managing its rolling debt. However, by 2023, with the Federal Reserve raising interest rates, the yield on 10-year Treasury bonds surged to 3.5% or higher. The interest cost of the new debt increased accordingly, meaning that the government faces heavier debt repayment pressure.
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The consequence of this situation is that government spending increases, the burden of debt rollover and interest payments grows, while economic recession and a series of tax reduction policies lead to a continuous decline in fiscal revenue, resulting in the continuous expansion of the fiscal deficit.
To make up for this deficit, the government can only choose to fill the fiscal gap by issuing bonds, which in turn bring higher interest payments, thus putting the United States into a “vicious cycle of debt,” and ultimately may lead to a “never pay off” predicament.
Here comes the question, since the US dollar is the global reserve currency, why doesn’t the United States just print money to solve its debt?
#02Why not just print money?
The US government’s financing methods mainly include issuing national debt, increasing the number of US dollars, and tax revenue. Why does the US government prefer to issue debt rather than directly printing money to finance it? There are two main reasons:
On the one hand, the issuance of currency in the United States is controlled by the Federal Reserve, not directly by the U.S. government.
The monetary policy of the United States is managed by the Federal Reserve, while fiscal policy (such as taxation and government spending) is formulated by the US government (through Congress and the President). Although the chairman of the Federal Reserve is nominated by the President and confirmed by the Senate, the operations of the Federal Reserve are completely independent of the day-to-day control of the President and Congress.
The US government does not have the direct power to intervene in the Federal Reserve, which means the Fed usually does not directly choose to lower interest rates or print money because of fiscal pressure, as the Fed’s monetary policy goal is mainly to achieve price stability (control inflation) and maximize employment, rather than directly responding to government fiscal pressure.
However, if the deterioration of the US fiscal situation may trigger economic slowdown and financial market volatility, it will indirectly affect the Fed’s policies.
On the other hand, printing money is not a “panacea”, but a double-edged sword that may plunge the United States into deeper trouble.
As the world’s currency, the US dollar gives the United States a powerful “coinage privilege”. Thanks to the global demand for the US dollar, the United States can not only easily finance, but also purchase almost all goods in the world with the US dollar - after all, 60% of global foreign exchange reserves and 40% of global trade settlements rely on the US dollar.
However, this does not mean that the Federal Reserve can print money at will. The widespread circulation of the US dollar does not equal unrestricted currency issuance. If the Federal Reserve excessively prints money, the newly added dollars will eventually flow back to the United States, which will undoubtedly exacerbate domestic money supply and push up inflation.
This inflation pressure will lead to the depreciation of the US dollar, and may even render the US dollar as “worthless paper”, accelerating the global “de-dollarization” process.
At the same time, the increasing US dollar in the market will intensify investors’ concerns about risk. To cope with inflation, investors will demand higher returns, which means that the debt issued by the United States in the future will face higher interest rates. The increase in debt interest burden will not only fail to alleviate the fiscal dilemma of the United States, but will make the debt problem more serious, entering a “vicious cycle”.
So, although printing money can avoid high interest burden in the short term, it will lead to currency depreciation and economic instability in the long term. Issuing bonds can provide low-cost financing from the international market. Many countries and enterprises hold US dollars as reserve currency, which gives the United States an advantage in low-cost financing, especially through issuing US treasury bonds to raise funds.
However, it is worth noting that excessive reliance on debt financing may temporarily alleviate short-term funding needs, but in the long run, this “borrowing more money” strategy undoubtedly exacerbates the financial crisis. On the one hand, the government needs to face the growing debt burden, on the other hand, it has to rely on debt financing, which may lead to increasingly serious financial problems.
If the Federal Reserve does not cut interest rates or even raise them, it could lead to a worsening of the U.S. fiscal deficit, ultimately affecting the stability of the U.S. economy and causing a decline in global confidence in the U.S. dollar, and even the possibility of the U.S. facing financial bankruptcy.
#The Federal Reserve has to cut interest rates.
To break this vicious cycle, theoretically there are two ways out: increasing federal income or reducing fiscal expenditure. However, in reality, the implementation of both is full of difficulties - Trump’s tax reduction policy will further reduce income, and considering the global military strategic position of the United States and domestic political pressure, it is almost impossible to cut the defense budget.
In this case, the Federal Reserve may choose to cut interest rates to alleviate the government’s debt burden. While interest rate cuts may not fundamentally solve the debt problem, they can temporarily relieve some of the pressure on interest payments and give the government more time to deal with the massive debt burden.
However, the impact of the rate cut goes far beyond this. In fact, it also aligns closely with Trump’s ‘America First’ policy. One of Trump’s core policies is to promote the reshoring of manufacturing. He hopes to enhance the competitiveness of domestic production, especially in terms of price, through measures such as tax cuts and deregulation. The rate cut will weaken the dollar, making American goods cheaper in the international market, thereby enhancing the global competitiveness of American manufacturers.
Of course, new problems will also arise with the interest rate cut.
The biggest motivation for global investors, including central banks and institutional investors from various countries, to purchase US Treasury bonds is based on the ‘golden credit’ of the US dollar and the fiscal endorsement of the US government. However, as the US fiscal deficit continues to expand, the risk premium of US Treasury bonds is starting to rise. In other words, investors may demand higher returns (i.e., interest rates) to compensate for possible risks.
At this time, if the US bond interest rate does not rise but falls, the attractiveness of US bonds will inevitably be greatly reduced, which may greatly reduce the demand for US bonds, especially against the background of gradually declining US dollar credit, and the willingness to purchase US bonds will be further weakened.
In fact, many countries that hold U.S. bonds are starting 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 countries used to buy U.S. bonds through trade surpluses to finance the U.S. economy, and now this “capital chain” is gradually breaking.
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Image source: Huayuan Securities
In this case, the Fed is forced to buy Treasury bonds that “cannot be sold”, which directly leads to the expansion of its balance sheet, which is a typical “balance sheet expansion” behavior. Since the onset of the pandemic, the Fed has rapidly ramped up its asset purchases in the face of economic shocks, causing its balance sheet to swell dramatically in the short term. As of early 2024, the total size of the Fed’s balance sheet has reached about $8.5 trillion.
The Federal Reserve’s continued “expansion” of its balance sheet has increased market liquidity. If the economy recovers, consumer confidence rises, and market demand warms up, excessive money supply may eventually lead to high inflation. The Trump administration may further intensify inflationary pressures by imposing tariffs and implementing tough immigration policies, which will raise production costs. This situation will clearly increase the pressure on the Federal Reserve to continue cutting interest rates.
The Fed is in a dilemma – although interest rate cuts can ease debt pressure, in the “de-dollarization” trend, low interest rates will further weaken the attractiveness of U.S. bonds, forcing new debt to rely on the Fed to expand its balance sheet, which may trigger high inflation; Interest rate hikes will help maintain the “borrow new debt for old debt” model, but it will increase the risk of fiscal collapse in the United States, and even affect the economy as a whole.
But choose the lesser of two evils.
As we mentioned earlier, although the risk of economic confrontation between China and the United States is accumulating, this confrontation is not without limits, but has certain boundaries and constraints. Once these boundaries are broken, the situation faced by the Federal Reserve will be more severe. Therefore, high inflation may not necessarily erupt as expected.
All in all, the Federal Reserve has almost no choice but to embark on a path of continuous interest rate cuts, and Powell’s ‘expectation management’ will not be effective for long. This is not only the inevitable choice for the United States, but also provides greater operational space for our country’s monetary policy. At the same time, this once again supports our previous view - in the long term, the dollar will trend downward and gold will trend upward.
