In CNBC’s article “Investors want the Fed to save the market, but an emergency cut could make things worse,” Jesse Pound quotes Lawrence McDonald, a bestselling author and market risk expert, saying, “If they do that, they weaken the dollar, they actually strengthen the yen, and this whole carry trade gets worse. When you have this type of move, you’re potentially blowing up counterparties. And it’s going to take at least three or four weeks to figure out where the bodies are buried,” The recent decline in the global stock market has led to increased calls for action by the Federal Reserve, but such actions might cause more problems than they solve. Lawrence warns that an emergency rate cut by the Fed could unintentionally weaken the dollar. This could strengthen the yen, which would worsen issues with the carry trade—a strategy where investors borrow in low-interest-rate currencies like the yen to invest in higher-yielding assets. McDonald cautions that a rate cut might destabilize currency exchange rates and worsen the current financial turmoil.
This market instability is mainly due to recent changes in Japan’s monetary policy. Japan’s historically low interest rates allowed investors to borrow yen cheaply and invest in assets with higher returns worldwide. However, in late July, the Bank of Japan raised its benchmark interest rate and reduced its bond-buying program, disrupting this pattern. The appreciation of the yen has led to a rapid unwinding of the carry trade, increasing pressure on global markets and exposing systemic weaknesses.
McDonald suggests that while the Fed might consider using its balance sheet to ease market pressures, a rate cut could bring significant risks. The complex effects of the carry trade unwinding might take weeks to understand fully, and the potential for destabilizing financial partners means the Federal Reserve should carefully weigh other options during this challenging time.
Comments