The US Federal Reserve has a rather checkered history in Asia, particularly since the mid-1990s.
The last time the US central bank tightened with the ferocity it did in recent years was between 1994 and 1995. That doubling of short-term rates within 12 months paved the way for the 1997-98 Asian crisis as a runaway dollar rally destabilized the region’s currency pegs.
Since then, the 2008 “Lehman shock” that the Fed was slow to see coming and the 2013 “taper tantrum” have disproportionately rocked Asian markets.
Asia also bore the brunt of the Fed’s 2022-2023 tightening cycle. The dollar’s surge in response to Fed Chairman Jerome Powell’s rate hikes saw epic waves of capital zooming toward US assets.
Yet might the Fed’s rate cuts unleash a different kind of turmoil in Asia? It could indeed if economist Stephen Jen is right.
The chief executive of Eurizon SLJ Capital thinks Chinese companies might dump roughly US$1 trillion of dollar-denominated assets as Team Powell undoes its most recent rate hike campaign.
In fact, Jen predicts something of an “avalanche” as a weakening dollar sends waves of repatriating capital China’s way, upending currency markets in the process.
Granted, Jen has warned of this dollar-dumping dynamic for a couple of years now. In June 2023, for example, Jen argued that “Chinese corporates continue to hoard dollars. The total stock of dollars held by Chinese entities continues to rise. The dollar’s high carry may at present seem enticing to Chinese entities, but this configuration is fundamentally unstable.”
The scenario about which Jen has been warning: “Prospective rate cuts by the Fed and/or an economic reacceleration in China could lead to a precipitous fall” in the dollar-yuan rate “as corporate treasurers in China scramble to sell the dollars they don’t need to have.”
Since the Covid-19 pandemic, mainland companies have gobbled up more than $2 trillion of overseas investment, a bet on higher-yielding assets than punters often find in China. As Powell begins ratcheting rates lower, those holdings could grow less attractive.
As a critical mass of mainland companies decide to pull funds back home, upwards of US$1 trillion will be on the move as the gap between China and US rates narrow, Jen reckons. Importantly, Jen points out that his guestimate could be “conservative.”
Now, as Powell declares “the time has come for policy to adjust” toward less restrictive conditions, Chinese selling risks may be upon us. It’s worth noting, Jen adds, that companies swapping out of dollar assets could see the yuan strengthening by up to 10%.
It’s worth noting, too, that the repatriation dynamic coursing through China in the months ahead could broaden to companies around Asia.
This isn’t a risk many have on their Bingo cards. Asia’s markets have generally been cheered by Powell’s pledge on August 23 that “we will do everything we can to support a strong labor market as we make further progress toward price stability.”
The same with Powell’s confidence that the US can achieve a so-called “soft landing,” a remarkably rare occurrence. “With an appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2% inflation while maintaining a strong labor market,” Jen tells Bloomberg.
Asian bourses rejoiced amid news Powell “has rung the bell for the start of the cutting cycle,” says Seema Shah, chief global strategist at Principal Asset Management.
The real gains could be in Asia’s “laggard” markets, notes Chetan Seth, strategist at Nomura Holdings. As Seth writes in a recent note: “We think the relatively safe harbor is likely to be markets and sectors that are uncrowded (parts of ASEAN) and more domestically driven markets (India/ASEAN). Investors in this case have to be far more defensive and cut back further on Asian cyclical markets such as in North Asia.”
Yet other risks abound. Count Jen among the economists who worry that central banks from Washington to Tokyo have pumped too much stimulus into the global financial system in recent years, fanning inflation.
As Powell said in July: “Go too soon, and you undermine progress on inflation. Wait too long or don’t go fast enough, and you put at risk the recovery. And so, we have to balance those two things. It’s a rough balance.”
Trouble is, the costs of a policy mistake are growing exponentially with the high and rising US national debt, which recently topped US$35 trillion. This milestone was reached just a few months before Americans go to the polls on November 5 to elect a new president.
In one corner, Democratic nominee Kamala Harris is detailing spending plans sure to add trillions of dollars’ worth of new public debt. Donald Trump, too. Along with another budget-busting multi-trillion tax cut, Trump is hinting at relieving the Fed of its role as independent arbiter of US interest rates.
During his first term as president from 2017 to 2021, Trump browbeat Powell into cutting rates in 2019 when the US didn’t need it. Trump also threatened to fire Powell, an unprecedented threat by a US leader.
In a second term, the “Project 2025” scheme that Republican activists cooked up for a Trump 2.0 White House could see the Fed’s power curtailed.
In such an uncertain world, though, the Fed pivoting toward monetary accommodation isn’t necessarily straightforward. The view driving this Asian stock rally is “broadly correct,” at least in the medium-term, says Tan Kai Xian, economist at Gavekal Research.
“Rate cuts will reverse the recent contraction in US liquidity, which will support US aggregate demand, after a lag,” Tan notes. “But in the shorter term, rate cuts will squeeze corporates’ interest income, and therefore their profits. This will disproportionately hit big companies sitting on large cash mountains and may lead to their relative underperformance.”
The effect, Tan notes, “will be bigger than commonly believed. Handouts during Covid allowed US companies to build up sizable cash reserves – even if the path was indirect, as businesses sold stuff to households in receipt of stimulus checks.”
When the Fed cuts interest rates, interest income will fall. “The near-term drag on corporate profits could discourage capital spending, which would have a dampening effect on US economic growth, at least before the lagged boost to aggregate demand kicks in,” Tan says. “In the short term, then, rate cuts could weigh on large-cap US equities relative to bonds.”
Jen thinks the Powell might cut rates more assertively than many investors think as headline US inflation rates continue to decline. Washington’s dual budget and current account deficits could add to downward pressure on the global reserve currency. That, Jen argues, could see the yuan appreciating more than many investors expect.
The yuan’s gains could be even bigger if the People’s Bank of China avoids moves to offset dollar liquidity. Odds are the yuan will experience upward pressure once the Fed begins cutting rates as soon as September 18. Pressure will intensify if the Fed hints at additional easing moves.
This could cause tension between PBOC Governor Pan Gongsheng and Xi’s economic team. Over the last year, Beijing has been surprisingly tolerant of a rising yuan even as global export markets grew more competitive.
Xi has been working to increase trust in the yuan and avoid giant property developers from defaulting on their offshore debts. Yet a skyrocketing yuan that dents growth prospects might be even more unwelcome.
The clouds on China’s economic horizon can be seen in this week’s $55 billion stock crash in Temu-owner PDD Holdings. It’s a sign that China’s growth engines are still cooling despite Beijing’s effort to boost household demand.
Nor does the external sector look particularly promising. This week, Canada slapped a 100% tariff on China-made electric vehicle imports, following the lead of the US and European Union.
Nor is the current US election cycle likely to offer Team Xi a respite. Both presidential candidates, Trump and Harris, are trying to outdo each other with anti-China rhetoric and trade policies.
All this explains why China’s foreign exchange watchdog has been paying very close attention to sharp yuan-dollar moves. And why things might play out in very different ways than many investment funds currently believe.
“The pressure will be there” on the yuan to rally, Jen tells Bloomberg. “If we just assume half of this amount is the money that is ‘footloose’ and easily provoked by changing market conditions and policies, then we are talking about $1 trillion worth of fast money that could be involved in such a potential stampede.”
Follow William Pesek on X at @WilliamPesek
