Fed cuts ripple across Asia, changing capital flows

The article was first published in The Business Times on 28 September 2024.

Historically high US rates and the resulting strong greenback have attracted capital to America’s financial markets and – by extension – drained liquidity from the rest of the world. The start of the Fed’s cutting cycle should start to change the direction of investment flows.

Asia’s currencies are usually the first to experience the effect of changing US monetary conditions. Forward-looking currency markets often price in moves weeks and sometimes months in advance.

Economies closest to the US epicentre – such as US dollar-dependent Hong Kong – have felt the impact of the start of the Fed’s easing cycle almost immediately.

The day after the Fed’s announcement that it would cut interest rates by 50 basis points (bps), Hong Kong’s Monetary Authority cut its benchmark rate by 25 bps.

Other central banks – such as Indonesia and the Philippines – which in the past followed the Fed, this time pre-empted the US move with their own cuts. We expect India, Australia, and South Korea to ease their rates in the months and quarters ahead.

Global liquidity conditions should remain supportive in 2025. We expect the Fed to cut rates by another 50 bps in total this year and a further 100 bps in 2025. That would mean that the US has achieved a soft landing.

This cutting cycle would take US interest rates to the so-called “neutral” level, neither stimulating nor stalling America’s economy.

Despite the possible impact of Asia’s relatively stronger currencies on their exports, this would be a constructive macroeconomic environment for the region.

We anticipate modest strengthening of Asia’s currencies against the US dollar.

On a 12-month horizon, we see the Japanese yen trading at 135 to the US dollar, and China’s yuan reaching 7.10.

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The recent era of exceptional US financial asset performance has seen global capital – in search of growth and earnings – naturally flow towards America’s markets.

Higher yields and high-earning, innovative US markets have offered investors opportunities that Asia’s markets have simply been unable to match.

As a result, emerging markets in general and Asia in particular, have struggled to attract investment.

Is that about to change? Lower US rates diminish the attractions of US assets and therefore investors’ need for US dollars.

Extended US equity valuations and, until very recently, concentrated US equity market performance, suggest that rotation by size, style, sector and geography – including opportunities in emerging markets – is entirely possible.

Capital is already seeking opportunities outside the US. Assuming the risks around the US elections and geopolitical risks are avoided, the global economic scenario of stable growth, declining interest rates and low rates of inflation supports appetite for risk assets.

Equities usually rally in the first 12 to 18 months after a rate cut, assuming no recession – which suggests that the range of attractive equities could expand, possibly extending to emerging markets.

The yield curve is normalising as short-dated yields fall faster than long Treasuries, implying receding recession risk. Credit spreads – both investment grade and high yield – show equity investors’ appetite broadening beyond US mega-caps.

In currency terms, decades of history show that the weaker the US dollar, the more likely Asian equities are to outperform. 

Put differently, Asian equities rarely outperform during long periods of US dollar strength.

A weak US dollar supports Asia’s economies in many ways. It makes the region’s exports cheaper for US consumers, boosting American demand and Asian corporate earnings. A weak greenback is also positive for commodity exporters such as Malaysia and Indonesia, and better earnings expectations encourage capital flows into local equity markets, boosting demand for local currencies.

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Finally, a positive feedback loop for investors often encourages further capital flows, especially when – as now – earnings and valuations look supportive in Asia’s equity markets.

A period of weakening US dollar and falling US rates can favour Asian greenback-denominated bonds. Local currency bonds may offer both yield and potential currency gains.

Certain Asia-Pacific markets – for example Australia, India and Indonesia – offer higher yields than their US equivalents. That can enhance and diversify overall portfolio returns.

In turn, exposure to local currency bonds can help to mitigate investors’ exposure to fluctuations in the US economy.

Source: The Business Times © SPH Media Limited. Permission required for reproduction.