This article first appeared in Forum, The Edge Malaysia Weekly on August 19, 2024 - August 25, 2024

Whichever way the US Federal Reserve (Fed) decides on interest rates in its meeting next month, it will likely cause jitters in the global financial markets.

Following the latest inflation data coming out of the US, traders are expecting the central bank to cut the base rate by 25 basis points (bps) from the current rate of between 5.25% and 5.5%. The US inflation rate, which came in at 2.9%, is the lowest since 2021 and far below the 9.1% recorded in June 2022.

High inflation in 2022 prompted the Fed to raise the interest rate from almost 0% to 5.25% by June 2023, causing a significant jump in borrowing costs within a space of about 15 months. Since then, inflation has been falling, which has led to suggestions that the Fed will reduce rates next month.

However, the question is, would a 25bps cut soothe the nerves of investors who are looking at a possible recession in the US?

The fear of recession is due to the US unemployment rate growing to 4.3% in July, the fourth straight month of increase. The rising unemployment rate suggests a slowing economy, which some fear could tip into a recession, hence the need for the Fed to make a bigger rate cut of 50bps.

But there is also a view that the US economy could achieve a “soft landing”, which means a gradual slowing down and not tipping into negative growth. Data such as improved retail sales and lower jobless claims points to a healthy economy.

The Fed is scheduled to have three more meetings by year end. The worst that could happen is that it does not cut rates at its next meeting on Sept 18 on account of inflation still being above its target of 2%.

That would spark another round of volatility in the global financial markets.

Outside the US, China is experiencing a slowdown in domestic consumption. Its second-quarter economic growth of 4.7% is below market expectations.

China’s economy has yet to return to its pre-pandemic levels with the property sector still recovering from a deflated bubble. Last year, the country’s economic growth was 5.2%, lower than the 6% recorded in 2019, prior to the pandemic.

This year, growth is expected to be around 5%. But this forecast is based on the assumption that the government will take measures to improve consumer sentiment, which is suffering because of the prolonged property overhang.

The central bank has cut interest rates several times in the past four years. The one-year loan prime rate, which is the benchmark for corporate lending, is at 3.35% now, compared with close to 4.5% prior to the pandemic.

The signal from China bond market yields suggests that the government could be forced to do more in the short term as yields on all tenures except for two-year debt paper have been falling.

Compounding China’s problem is the possibility of Donald Trump winning the next US presidential election. In his first term as president, Trump imposed tariffs to restrict China’s exports into the US. It sparked a trade war that affected the global economy.

For Malaysia and most of Asia, China is an important economic workhorse. If China’s economy picks up, the rest of Asia will also benefit. However, the Trump factor, the country’s slow recovery from the pandemic and prolonged recovery from its housing bubble have cast a shadow on the world’s second largest economy.

Asia’s other giant is Japan, which sparked the market turmoil on Aug 5. Japan raised its ultra-low interest rates from 0% to 0.25% on July 31, causing currency appreciation and the unwinding of yen carry trades.

Carry trades involve investors borrowing in yen, which has a low interest rate, and then reinvesting it in assets in other countries where returns are higher. Nobody knows how much more of the yen carry trades are left.

According to a report, cross-border loans originating from Japan amounted to US$1 trillion (RM4.43 trillion) as at the end of March this year. Not all of the US$1 trillion are necessarily carry trades, but an analyst estimates that at least 40% or more could have been used to invest in other places where the returns are higher.

Going forward, the Bank of Japan (BoJ) has embarked on measures to strengthen the yen by intervening in the domestic bond market. A combination of the BoJ’s measures to strengthen the yen and a cut in US interest rates points to a further appreciation of the yen, which is at 148 against the US dollar currently.

The strengthening of the yen will cause the unwinding of more carry trades, causing further turmoil.

Most of the global capital markets have regained the ground they lost due to the turmoil on Aug 5. Malaysia’s FBM KLCI index is above 1,600 points and the ringgit is continuing its splendid run to RM4.42 against the dollar.

However, the three major economic powers — the US, China and Japan — have their own sets of problems.

The Fed is under pressure to cut interest rates and it hopes to guide the economy to a soft landing instead of a recession. The property segment is still weighing down China as it struggles to lift consumer sentiment. As for Japan, the central bank is under pressure to strengthen its currency.

The worst that can possibly happen is if the US does not cut rates at the next meeting, China’s economy slows down and the BoJ’s measures to strengthen the yen against the dollar bear fruit, triggering another round of unwinding in the yen carry trades.

That would be the perfect storm.

M Shanmugam is a contributing editor at The Edge

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