Recent macroeconomic conditions have not been favorable for the narrative of interest rate cuts, yet the window for easing has not been completely shut. Attention should be directed towards three key lines of reasoning.

First Line of Defense / June Timeframe: A second downturn in U.S. stocks and Treasury bonds could expedite U.S.-Iran negotiations and the reopening of the Strait of Hormuz. Should oil prices subsequently decline, the premise for a rate-hike narrative could weaken.

Second Line of Defense / Q3 Timeframe: The interpretation of employment data is not self-contained; inflation serves as the ultimate arbiter. As long as core CPI remains stable, the possibility of rate cuts will not be extinguished.

Third Line of Defense / H2 Timeframe: Amidst a K-shaped economic divergence, if consumer spending continues to be weak, the Federal Reserve's employment objectives may not be satisfied merely with a stabilized unemployment rate but could demand a more substantial decline. In such a scenario, rate cuts remain a potential policy option.

Current market pricing for rate hikes is approaching an extreme. The direction of mean reversion in the second half of the year is more likely to lean towards monetary easing. Furthermore, the market's recent hypersensitivity to the rate-hike narrative does not stem from a genuine belief in imminent hikes but rather from stock market jitters at elevated levels. Once a pullback is complete and sentiment stabilizes, the rate-hike narrative is likely to fade.

The stronger-than-expected U.S. non-farm payrolls data for May has fueled a surge in rate-hike trading, with U.S. stocks, bonds, and commodities experiencing a collective decline last Friday. Looking ahead, is there still a chance for expectations of rate cuts to recover? What defenses must the rate-hike trading narrative breach to become the dominant theme in the second half of the year?

First Line of Defense / June Timeframe: A second downturn in U.S. stocks and Treasury bonds could expedite U.S.-Iran negotiations and the reopening of the Strait of Hormuz. Should oil prices subsequently decline, the premise for a rate-hike narrative could weaken. Current data points, including non-farm payroll additions, the unemployment rate, and the month-on-month core CPI, are not particularly strong compared to last year and exhibit more characteristics of bottoming out. Based solely on this data, the economy remains far from overheating to a degree that would force the Fed's hand to hike rates. The market's current pricing of hikes is largely a reaction to the specific macro backdrop of the Strait of Hormuz blockade and rising oil prices. If the strait reopens and oil prices fall by $10-$20 from their current level, it is questionable whether the same data would trigger market pricing for monetary tightening. It is noteworthy that the current rate-hike trading is significantly pressuring both U.S. stocks and bonds. Should the S&P 500 experience another 5-10% pullback, the probability of decisive geopolitical action would rise substantially, potentially catalyzing the full reopening of the strait. The U.S.-Iran ceasefire negotiations around April occurred against a backdrop of a 10% S&P 500 pullback and U.S. Treasury yields challenging 4.6%.

Second Line of Defense / Q3 Timeframe: The interpretation of employment data is not self-contained; inflation serves as the ultimate arbiter. As long as core CPI remains stable, the possibility of rate cuts will not be extinguished. The employment data itself is far from indicating overheating and cannot singularly catalyze rate hikes. The market's overreaction stems more from concerns about intensifying inflationary pressures. Therefore, the ultimate interpretation of the employment data hinges on the upcoming CPI release. If core CPI remains steady, marginal improvements in employment will not fundamentally impact Fed policy. Similar scenarios have recurred in 2024. At that time, non-farm payrolls frequently posted strong gains while the unemployment rate rose, leading to divergent market pricing. Often, a stronger-than-expected non-farm payroll report on a Friday would lead to pricing for tightening, only for a lower-than-expected CPI report mid-week to shift the market towards pricing for easing. Currently, the overall month-on-month core CPI continues to hover around 0.2% (with April's data affected by rental statistic adjustments and airfare volatility), showing no signs of a trending increase. The rise in the job vacancy rate and the decline in the unemployment rate have not had a significant immediate impact on wage growth; their influence is more leading in terms of long-cycle inflection points, typically concentrated around recessions, requiring observation of more data samples.

Third Line of Defense / H2 Timeframe: Amidst a K-shaped economic divergence, if consumer spending continues to be weak, the Federal Reserve's employment objectives may not be satisfied merely with a stabilized unemployment rate but could demand a more substantial decline. In such a scenario, rate cuts remain a potential policy option. The Fed's focus on employment is essentially because employment determines household income and consumption, which in turn drives overall economic growth momentum; the unemployment rate figure itself is not the key. Since 2016, due to immigration restrictions and a declining labor force participation rate, the overall supply of U.S. labor has weakened significantly. This has resulted in the unemployment rate stabilizing while the total income generated by the job market for households has not grown effectively. Metrics such as total non-farm payroll wages (hourly earnings * hours worked * number of workers), the wage component of household income, and real disposable household income are all showing decelerating growth or even turning negative. This implies that against the backdrop of constrained labor supply, achieving a stabilization and recovery in consumption requires more than just a peaking unemployment rate; a more substantial decline is necessary. Therefore, the current unemployment level still affords the Fed room for potential rate cuts. Moreover, unlike previous cycles where economic improvement coincided with rising rates, household consumption has been persistently weak in this cycle. If the Fed subsequently adopts a neutral or even hawkish stance, the negative feedback on traditional sectors like household consumption would intensify, making it difficult for the job market to maintain strength over the long term.

Conclusion: First, despite the current macro environment being less friendly to Fed rate cuts, the window for easing is not entirely closed. Subsequent focus should be on three logics: the reopening of the Strait of Hormuz; the stability of month-on-month core CPI; and continued weakness in consumer data. Second, current market pricing for rate hikes is approaching an extreme, and the direction of mean reversion in the second half of the year is more likely to be towards easing. Third, the market's recent sensitivity to the rate-hike narrative is also due to U.S. stocks being at extreme levels. Once a pullback is complete, sentiment is expected to ease, and the rate-hike narrative may fade.

Risk Warnings: U.S. inflation exceeds expectations, U.S. economic growth exceeds expectations, leading the Federal Reserve to continue tightening monetary policy, a sharp appreciation of the U.S. dollar, a rise in U.S. Treasury yields, a continued decline in U.S. stocks, a crisis of commercial bank failures, and the emergence of currency and debt crises in emerging markets. U.S. economic recession exceeds expectations, leading to a liquidity crisis in financial markets and forcing the Fed to turn to easing. The European energy crisis exceeds expectations, plunging the Eurozone economy into a deep recession, causing global market turmoil, shrinking external demand, and presenting policy dilemmas. Global geopolitical risks intensify, Sino-U.S. relations deteriorate beyond expectations, uncontrollable factors emerge in commodities and transportation, deglobalization deepens further, supply chains continue to be disrupted, and competition for related resources worsens.