The US Federal Reserve has had a rather checkered history in Asia, especially since the mid-1990s.
The last time the U.S. central bank tightened monetary policy as drastically as it has in recent years was between 1994 and 1995, when short-term interest rates doubled within 12 months, causing the dollar to surge, destabilizing regional currency pegs and sparking the 1997-1998 Asian crisis.
Since then, the 2008 “Lehman Shock” and the 2013 “Taper Tantrum”, which the Fed was slow to predict, have had disproportionately large impacts on Asian markets.
Asia also bore the brunt of the Fed's tightening cycle through 2022 and 2023. The dollar's surge in response to Fed Chairman Jerome Powell's interest rate hikes has led to huge flows into U.S. assets.
But could the Fed's rate cuts spark a different kind of turmoil in Asia? If economist Steven Jen is right, surely they could.
The CEO of Euryzon SLJ Capital believes Chinese companies could sell around $1 trillion worth of dollar-denominated assets as Powell's team backs off its latest campaign to raise interest rates.
In fact, Zhen predicts that the weak dollar will trigger an “avalanche” of capital inflows into China, disrupting currency markets in the process.
Indeed, Zhen has been warning about the dollar's weakening trend for several years. In June 2023, for example, Zhen argued that “Chinese companies continue to hoard dollars. The total amount of dollars held by Chinese companies continues to grow. While the high dollar carry may seem attractive to Chinese companies for now, this composition is fundamentally unstable.”
The scenario Jeng has been warning about is that “future interest rate cuts by the Fed or a re-acceleration of China's economy could cause Chinese corporate treasurers to rush to sell dollars they don't need, causing the dollar-to-yuan exchange rate to crash.”
Since the start of the coronavirus pandemic, mainland Chinese companies have gobbled up more than $2 trillion in overseas investments, betting on higher-yielding assets than are often found in China. Those holdings could become less attractive if Powell starts cutting rates.
Zheng predicts that as mainland Chinese companies bring capital back home en masse, it could drive more than $1 trillion in flows as interest rate differentials narrow between China and the U.S. Importantly, he notes that this estimate is likely “conservative.”
The risk of a sell-off by China could be looming now that Chairman Powell has declared that “it's time to ease policy.”It's also worth noting that the yuan could strengthen by as much as 10% if companies switch from dollar assets to the yuan, Zhen added.
It is also worth noting that the repatriation efforts taking place in China over the coming months could spread to companies across Asia.
This is not a risk that many have on their bingo cards. Asian markets have been largely receptive to Chairman Powell's Aug. 23 pledge to “do all we can to support strong labor markets as we make further progress toward price stability.”
Powell is confident the U.S. can achieve what's known as a “soft landing,” which would be extremely rare. “There's every reason to believe that with an appropriate easing of policy restraints, the economy could return to 2% inflation while maintaining a robust labor market,” Jen told Bloomberg.
Seema Shah, chief global strategist at Principal Asset Management, said Asian bourses were celebrating after the news that Powell had “ringed the bell to start the rate-cutting cycle.”
Nomura Holdings strategist Chetan Seth says the real gains may be in Asia's “lagging” markets. In a recent note, Seth wrote: “Relative safe havens will likely be less crowded markets and sectors (parts of ASEAN) and more domestically driven markets (India/ASEAN). In this case, investors will have to become much more defensive and further reduce exposure to cyclical markets in Asia, such as North Asia.”
But other risks abound. Jen is among a growing number of economists who worry that central banks from Washington to Tokyo have pumped too much stimulus into the global financial system in recent years, stoking inflation.
“If we act too early, we stunt inflation progress. If we wait too long or don't act fast enough, we put the recovery at risk. So we have to balance the two. And it's a difficult balance,” Powell said in July.
The problem is that the costs of policy mistakes are growing exponentially with the soaring and rising U.S. national debt, which recently surpassed $35 trillion — a milestone reached just months before Americans go to the polls to elect a new president on November 5.
On one side, Democratic candidate Kamala Harris has detailed a spending plan that is sure to add trillions of dollars worth of new public debt, as has Donald Trump, who has signaled he would relax the Federal Reserve's role as the independent arbiter of U.S. interest rates, along with trillions of dollars more in budget-busting tax cuts.
During his first term as president, from 2017 to 2021, Trump threatened Powell by forcing the U.S. to make unnecessary interest rate cuts in 2019. He also threatened to fire Powell, an unprecedented threat from a U.S. leader.
A second term could see the Fed's powers curtailed under a “Project 2025” plan devised by Republican activists for a Trump 2.0 White House.
But in such an uncertain world, it's not always easy for the Fed to reverse course and ease monetary policy. The views driving the Asian stock rally are “broadly correct,” at least in the medium term, says Tan Kai Hsiang, an economist at Gavekal Research.
“Cutting interest rates will reverse the recent contraction in U.S. liquidity and support U.S. aggregate demand for some time,” Tan said. “But in the short term, cutting interest rates will squeeze corporate interest income and therefore profits. This could disproportionately hit large companies with large amounts of cash, leading to relative underperformance.”
The impact is “likely to be larger than commonly thought,” Tan said, adding that “COVID-19 stimulus payments have allowed US companies to build up significant cash reserves, even if only indirectly through companies selling goods to households that received stimulus checks.”
If the Fed cuts interest rates, interest income will fall. “A short-term decline in corporate profits could dampen capital investment and hurt U.S. economic growth, at least until the delayed boost in aggregate demand kicks in,” Tan says. “Hence, in the near term, interest rate cuts could weigh on U.S. large caps relative to bonds.”
Zhen believes Powell may be more aggressive in cutting rates than many investors think as headline inflation in the U.S. continues to fall. Washington's dual budget and current account deficits could put more downward pressure on the yuan, the world's reserve currency. That could allow the yuan to rise more than many investors expect, Zhen argues.
The yuan could rise even more if the People's Bank of China avoids moves to offset dollar liquidity. The yuan would likely come under upward pressure if the Fed starts cutting interest rates as soon as September 18. Any hint of further Fed easing would intensify the pressure.
That could cause tensions between the central bank's governor, Pan Gongsheng, and President Xi Jinping's economic team. Beijing has been surprisingly tolerant of a stronger yuan over the past year, even as global export markets have become more competitive.
President Xi has sought to shore up confidence in the yuan and prevent big property developers from defaulting on overseas loans, but a surge in the yuan could be an even more unwelcome blow to growth prospects.
Dark clouds looming over China's economy were also evident this week when shares in Tem-owner PDD Holdings plunged by $55 billion — a sign that China's growth engine is still cooling despite Beijing's efforts to shore up household demand.
The external sector doesn't look particularly promising either: This week, Canada followed the United States and the European Union in imposing a 100% tariff on imports of Chinese-made electric vehicles.
The current US election cycle is also unlikely to give Team Xi any respite, with presidential candidates Trump and Harris vying with each other on anti-China rhetoric and trade policy.
All of this explains why China's foreign exchange watchdog is paying very close attention to any sudden fluctuations in the yuan against the dollar, and why things could play out quite differently than many investment funds currently think.
“There will be pressure for the yuan to appreciate,” Zheng told Bloomberg. “If we assume that half of this amount is 'free' money, easily stimulated by market conditions or policy changes, then we're talking about a trillion dollars' worth of surging money that could get caught up in such a potential run.”
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