Fed Decision: Yen Uncertainty Could Shake Emerging Markets

The upcoming Federal Reserve interest rate decision meeting has the potential to trigger a rally in the Yen, which could evoke memories of global volatility seen in August. This development is being closely monitored by many investors, given its potential massive impact on emerging markets. The August-evocative Yen surge, driven by the Bank of Japan's rate hike, significantly impaired the EM carry trade and caused the worst drop in the Nikkei 225 since 1987. Additionally, a substantial decline in U.S. employment figures led to a rise in the Wall Street volatility index, resulting in the worst monthly start for U.S. technology stocks since 2008. Investors are currently divided on whether the Fed will commence its easing campaign with a typical 25 basis-point cut or opt for a larger cut of 50 basis points. A larger cut could raise concerns about the health of the U.S. economy and lead to the selling of assets in Asia's emerging markets. A stronger Yen may prompt investors to abandon their carry positions in risky assets financed through the Japanese currency. Conversely, a 25 basis-point cut might benefit stock markets, with the smaller markets of Southeast Asia being key beneficiaries. The Yen remains in focus as its performance is closely linked to expectations of Fed rate cuts. On Monday, the currency crossed the 140 Yen per U.S. Dollar mark, reaching its strongest level this year, thereby increasing speculation about a 50 basis-point cut. Japanese investors are worried that a larger Fed rate cut could further strengthen the Yen and hurt the profits of the country's export industry. Traders, hedge funds, and institutions vividly recall last month's sharp Yen rally triggered by the Bank of Japan's rate hike, which sparked a global market selloff. Following the Fed’s decision, attention turns to the Bank of Japan’s meeting on Friday. Although most economists do not expect policy changes, investors will be seeking clues about a potential further rate hike in December. Southeast Asia's smaller markets have come into focus for money managers preparing for a Fed policy shift. Four of the five best-performing Asian stock indexes this month are from this region, led by Thailand. In the past two months, fund managers have increased their positions in government bonds from Thailand, Indonesia, and Malaysia. They have been net buyers of stocks from Indonesia, Malaysia, and the Philippines for three months, making Southeast Asian currencies the best performers in emerging markets this quarter. In India, lower U.S. rates could prompt the Reserve Bank of India to reduce borrowing costs. This prospect has attracted foreign investors and driven major stock indexes to record highs. A Fed rate cut could strengthen China’s Yuan by narrowing the yield gap between U.S. and Chinese government bonds. However, sentiment remains cautious as investors await whether weak economic data will prompt authorities to further ease fiscal and monetary policies. The CSI 300 Index closed last week at its lowest level since 2019. Not all Asian markets will benefit from the Fed's decision. Momentum indicators suggest that the rally in Australian bonds might seem overdone. Yields on policy-sensitive three- and ten-year bonds fell to their lowest levels since June earlier this week. The continuation of the rally depends on whether the Fed shows enough dovishness to meet expectations for an end rate of around 2.75%, given the strong correlation between Australian and U.S. government bonds.