In the early hours of December 19, the Federal Reserve announced its decision to cut interest rates by 25 basis points (BP) as expectedHowever, what caught the attention of market analysts and economists alike were the hawkish signals released by the Fed, indicating a possibility of only two rate cuts being implemented by 2025, a sharp contrast to the four cuts predicted in the previous September announcementThis shift in outlook has led some market participants to speculate that any hopes for rate reductions in the coming year might be dashed altogether.

The immediate aftermath of the announcement sent shockwaves through the financial markets

Major American stock indices recorded their largest single-day drops in months, resulting in a plunge across both stock and bond marketsThe S&P 500 index and the Nasdaq Composite fell sharply by 2.95% and 3.56%, respectively, while the US dollar index approached alarming levels at nearly 108. As trading continued in Asia, all major indices, including the Shanghai Composite, Hang Seng Index, and Nikkei 225, saw substantial declines, with the Shanghai index dropping nearly half a percent and the two others close to one percent.

Despite the onslaught of negative sentiment, traders had anticipated the potential for a pause in rate cuts during January, yet they viewed the chances of the Fed holding rates steady in March as falling below 50%. Meanwhile, Nick Timiraos, a reporter known for his insights into Fed communications, indicated that internal discussions hinted at a lack of clarity regarding the rationale for further rate cuts if the economy maintains its robust growth momentum.

The Complexity of Inflation in Rate Cuts

After the Fed's decision on Thursday to reduce rates, they suggested a more cautious stance regarding any future cuts

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Jerome Powell, the Fed Chair, acknowledged the difficulty of the decision madeHe stated that this marks the beginning of a new phase, emphasizing the need for a careful approach when considering further rate reductions.

The unexpected turnaround caught investors off guardDiane Swonk, chief economist at KPMG, remarked that market assumptions predicting a gradual decline in rates of one cut per meeting were fundamentally flawed.

According to newly released economic projections, Fed officials anticipate that inflation will be more stubborn than previously expected next year

Specifically, the core personal consumption expenditures (PCE) inflation is projected to rise to 2.5%, up from the earlier forecast of 2.1%. This PCE measure is the Fed's preferred gauge for tracking price changesIndeed, inflation indicators have failed to perform as desired; the core PCE rose 2.8% year-on-year in October, surpassing earlier estimates of 2.2%.

Some analysts have suggested that this development renders the 50 BP rate cut from September as a misstepEven more troubling is the Fed's current assertion that reaching a 2% annual inflation target may not happen until 2027, a significant delay from the previous expectation of achieving this benchmark by 2026.

In a stark contrast to the September forecasts predicting four rate cuts in 2025, the Federal Reserve's latest guidance suggests only two might occur

The recently unveiled dot plot indicates that committee members have adjusted their median rate forecasts for 2025 from 3.4% to 3.9%, while also raising expectations for rates at the end of 2026 from 2.9% to 3.4%. Additionally, the long-term neutral rate has also been lifted from 2.9% to 3.0%.

Despite this, PIMCO expressed that the likelihood of a return to rate hikes remains lowThe Fed seems determined to witness further progress on inflation or a rise in unemployment before considering resuming a more accommodative cycle.

Inflation as a Potential Threat to US Stocks

Despite bleak indicators, there is a facade of optimism hanging over the US stock market

Wall Street has adjusted its target for the S&P 500 to a staggering 6,500 points by 2025. The index had previously come close to the 6,100 mark before plunging to 5,872.16 following the recent downturn.

Market strategist Huang Senwei from Lianbo Fund remarked that the prevailing assumption is that the US economy will continue to maintain a ‘soft landing’ while inflation returns to an upward trend, initially imposing limited pressure on the stock marketHowever, he warned that should inflation persist above 4% for an extended period, significant challenges could arise for US stocks.

Historical data over the past century illustrates that when inflation rates are below 4%, US stocks tend to outperform government bonds

Yet, when inflation exceeds 4% and remains high, the stock market’s returns plummet sharplyHence, how policymakers navigate the inflation question moving forward could have profound implications.

On a promising note, the earnings growth of US stocks remains robustProjections for the information technology sector indicate earnings growth of 18% and 23% for 2024 and 2025, respectively, reflecting strong fundamentals in the tech sectorThe central concern, however, lies in the high valuations, which may lead to lower tolerance for deviations from predicted quarterly performance, potentially causing significant price fluctuations if results fall short of market expectations.

During the bear market of 2022, tech stocks experienced substantial declines due to disappointing earnings returns

In contrast, 2023 and 2024 are expected to witness a resurgence in tech stocks led by strong profit performancesNotably, in 2025, particularly in the first half, the growth in earnings between tech firms and those in other sectors is expected to convergeAnalysts recommend that investors consider opportunities in non-tech sectors such as healthcare and industrialsFurthermore, small-cap stocks, which are particularly sensitive to changes in interest rates, could benefit significantly from tax cut policies.

Morgan Asset Management noted that there haven’t been any significant changes in the overall macroeconomic landscape

They still expect the US economy to maintain stable growth, with a gradual cooling labor market and inflation returning to normal levelsThe anticipation of a 50 BP rate cut next year suggests that the Federal Reserve may retain some leeway for monetary policy easing, providing a backdrop that may support profit growth for businesses and the stock market amid the ongoing relaxation of tax and regulatory policies.

Asian Markets in Decline, Yuan Falls Below 7.3

In light of the negative developments in the US, Asian markets took a significant hit

However, given that the path for US rate cuts has not reversed and the US economy appears to be quite stable, many institutions maintain a positive outlook for Asia.

According to analysts at Amundi, Japan and Indonesia's stock markets are expected to perform quite well in 2025. Although India is experiencing high valuations and could face temporary macro headwinds, its longer-term growth outlook is still regarded as favorableThe allocation of overseas funds in China has remained relatively low, as investors look for signs of market reversals.

For the Chinese market, tariffs are anticipated to remain a significant challenge in 2025, alongside the Fed's actions

Analysts suggest that if the US imposes a unified tariff of 10% on other global countries, it could further pressure global demand and create additional hurdles for China in circumventing exports to the USThe increasing risk of a fragmented global supply chain could also undermine corporate confidence moving forward.

Nevertheless, due to the low positioning of international capital in the Chinese stock market, the potential for further outflows appears limitedZhao Wenli, Chief Hong Kong stock strategist at Jianyin International, indicated that the upcoming Central Economic Work Conference and the National People's Congress in March will serve as important windows for potential policy support; the Fourth Plenary Session, set to focus on deepening reforms and addressing structural economic challenges, will likely draw significant attention.

Looking ahead, the overall trend of Hong Kong stocks is predicted to be lower at the start of the year, followed by a recovery

Analysts estimate that the Heng Seng Index will fluctuate between 18,000 and 23,000 points, with a focus on high dividend stocks, sectors benefitting from fiscal policies, and high beta sectors such as non-bank financials, real estate, and growth-oriented technology stocks.

Regarding currency exchange rates, the Chinese yuan fell below the 7.3 level against the US dollar as the interest rate differential between China and the US widened significantlyThe dollar index surged past the 108 mark, while the yield on the US 10-year treasury bond rose 10 BP to reach 4.5%, which was previously hovering around 3.6% in mid-September

This expansion of interest rate differentials reflects the highest margins detected since 2002.

However, recent indicators, including the daily official midpoint rate, have not suggested a passive approach from the central bank regarding currency depreciationFor example, Huachuang Securities’ calculations indicate that the official midpoint rate on December 12 was reported at 7.1854, with the counter-cyclical adjustment factor showing a significant stabilizing signal.

Looking forward, Wall Street investment banks project that by the end of 2024, the dollar rate against the yuan will stabilize around 7.3, while in 2025 the outcome will depend on external factors, with consensus estimates clustering in the range of 7.4 to 7.6. Rob Subbaraman, head of global macro research at Nomura, noted that if the European Central Bank proceeds with five rate cuts next year, it could support a strong dollar index at least through the first half of 2025.

UBS analysts highlighted that the upcoming Central Economic Work Conference will emphasize maintaining a stable renminbi within a "reasonable equilibrium". "The Chinese central bank may permit a depreciation of the yuan against the US dollar of 5%-8% to counteract some external shocks from increased US tariffs