(Bloomberg) -- A potential decision by the Federal Reserve this week that triggers a rally in the yen may unsettle emerging-market investors, reviving memories of the global volatility seen in August.
Last month’s yen rally, driven by the Bank of Japan’s rate hike, hit the EM carry trade hard and sparked the worst rout in the Nikkei 225 since 1987. This, combined with a significant miss in US nonfarm payrolls, led to a spike in Wall Street’s favorite volatility gauge, with US technology stocks suffering their worst start to a month since 2008.
This time, there are similarities. Investors are split on whether the Fed will kick off its easing campaign with a standard 25 basis point cut or a larger one. A half-point reduction may raise doubts about the health of the US economy, prompting a selloff in emerging Asia assets. It may also drive the yen stronger, prompting investors to unwind their carry positions in risk assets funded by the Japanese currency.
On the other hand, a quarter-point cut may work in favor of equities, with the smaller Southeast Asian markets likely being key beneficiaries.
Here’s a look at what market participants are expecting.
Watching Yen
The yen’s trajectory is closely tied to expectations around Fed rate cuts. The currency surged past the 140 per dollar mark on Monday, reaching its strongest level this year, as speculation grew about a half-point cut.
This has spooked Japanese investors, as a bigger Fed cut may boost the yen further, hurting the earnings of the nation’s exporters. Traders, hedge funds and institutions still have fresh memories of last month’s sharp rally in the currency following the Bank of Japan’s rate hike, which fueled a wave of selling across global markets.
After the Fed’s rate decision, attention will turn to the BOJ meeting on Friday. While most economists anticipate no changes in policy, investors will be looking for any signals hinting at another possible hike in December.
Bets on Smaller Markets
The smaller Southeast Asian markets have become a top choice for money managers positioning for the shift in Fed’s policy. Four of the five best-performing Asian equity benchmarks this month are from the region, with Thailand leading.
For the past two months, fund managers have boosted positions in sovereign bonds in Thailand, Indonesia and Malaysia. They’ve been net buyers of Indonesian, Malaysian and Philippine equities for three months. These inflows have made Southeast Asian currencies the best performers in emerging markets this quarter.
India as EM Anchor
Lower rates in the US may prompt the Reserve Bank of India to reduce borrowing costs. This prospect has attracted foreign investors to local shares, pushing up the main equity indexes to a record on Tuesday.
“A rate cut by the Fed will be positive for valuations and can begin India’s own cycle of interest rate cuts with a lag,” said Sumeet Rohra, a fund manager at Smartsun Capital Pte. in Singapore. India’s economic growth rate will help attract more flows, he added.
India’s rising heft in emerging market allocation may also get a boost following a Fed rate cut. The country — long touted as “the next China” — has emerged as a favorite among investors, driven by its robust economic growth, a growing middle class and burgeoning manufacturing sector.
Mixed Mood on China
Yuan strength may gather pace if the Fed rate cut shrinks the yield gap between US and Chinese government bonds.
Still, the mood is cautious as investors wait to see whether weak economic data over the weekend will prompt authorities to ramp up fiscal and monetary stimulus. The CSI 300 Index closed at its lowest level since 2019 last week.
A rate cut by the Fed may mean China has more room to ease without currency worries, but “given the host of issues that China is facing — from domestic economic weakness to external tariffs — a rate cut cycle may not be as beneficial as before,” said Vey-Sern Ling, a managing director at Union Bancaire Privee.
Australian Bonds Looking Stretched
That said, not all Asian markets will benefit from the Fed. Momentum indicators suggest the rally in Australian bonds is starting to look overextended, with yields on policy sensitive three- and 10-year bonds falling to their lowest since June earlier this week. Bond investors will also closely monitor the local jobs data for August, due just hours after the Fed decision
Whether the rally extends will depend on the Fed being dovish enough to meet expectations for a so-called terminal rate around 2.75%, given the strong correlation between Australian and US Treasuries, according to National Australia Bank. The jobs data may also prompt the market to scale back expectations for the Reserve Bank of Australia rate cuts over the next six months, said Kenneth Crompton, a senior fixed income strategist in Sydney.
“The shorter duration ACGBs are definitely looking stretched here relatively to RBA expectations,” he said. “Longer end I don’t think has much value left either.”
--With assistance from Matthew Burgess.
(Updates with details on yen-induced global volatility in August, adds section on Australian bonds)
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