Equity ebullience isn’t universal – Just ask China

Stocks soared again on Friday, capping off a stellar week as investors revelled in anticipation of the Federal Reserve’s expected rate cuts this week. The market is buzzing with excitement as the drumbeat grows louder for a sizable drop in interest rates. With momentum building, the Fed’s next move could spark even more optimism, pushing the bull run even higher.

This week's Fed meeting is setting up to be one of the most eagerly awaited in recent memory—and not because of any grand reveal, but because, for once, nobody knows what's coming. Typically, by now, investors have made their bets, donned their poker faces, and settled in for the ride. But this time? The suspense is palpable—thick enough to slice with a butter knife.

The usual market calm is nowhere to be found, replaced by an uneasy sense that anything could happen. Will Powell and his team go big with a 50-basis-point cut, or will they play it safe and trim just a quarter-point? The markets can’t decide, and that uncertainty is sparking a game of rate-cut roulette, with traders flipping back and forth like they’re hedging every bet at the table.

The odds of a half-point rate cut have bounced around like a pinball game. Just a month ago, Fed Funds futures were pricing at a 53% chance of a 50-basis-point cut. By midweek, that number had dropped to a paltry 10%, only to shoot back up to 50% by Friday afternoon, spurred by a juicy Wall Street Journal report suggesting the debate inside the Fed is still raging.

As the drums beat louder, investors are holding their collective breath. And that’s rarely a good thing—half the market will get blindsided if things don’t break right.

But there’s a method to the madness behind calls for aggressive rate cuts: With core inflation quietly hovering around the Fed's target and the jobless rate at a long-term equilibrium of 4.2% and inching higher, the rationale for keeping rates 200+ basis points above neutral is fading fast. It’s no longer about just cooling inflation—now it's about rebalancing the economic scales before they tip too far.

Now might be the perfect time to signal that the Fed is serious about an "insurance cut"—proactively easing to cushion the blow of rising unemployment. If Powell and his team can shift from reactive to proactive, markets will lap it up, clearing the runway for that elusive soft landing everyone’s hoping for.

The real show won't stop there, even if the Fed surprises with a half-point cut. All eyes will quickly shift to the bond market’s laser focus on the updated 'dot plot' and every nuanced hint buried in the FOMC’s statement. And then, of course, there's Jay Powell’s press conference—essential viewing for traders eager to dissect every syllable like it’s a cryptic code for future rate moves. Because let’s be honest: it’s not just about the first cut; it’s about cracking the rhythm of what’s coming next. Will it be a steady 25-beat waltz or a rapid-fire cha-cha of deeper rate slashes? Stay tuned.

All of that equity enthusiasm doesn’t mean everyone’s riding high—ask China. While global markets are revelling in the rally, China’s economy is stuck in a different gear, grappling with deflationary pressures and sluggish growth. The world’s second-largest economy is watching from the sidelines as other markets take off, and that contrast couldn’t be more stark. So, while the party rages elsewhere, China is still nursing a bad economic hangover.

China’s deepening woes

Deflation has been stalking China for over a year, but now it’s looking more like it’s ready to pounce, threatening to drag the world’s second-largest economy even deeper into the mire. The calls for big-time fiscal stimulus are growing louder by the day. China’s economic momentum faltered in August, with factory output, consumption, and investment cooling more than anticipated. To make matters worse, the jobless rate unexpectedly hit a six-month high, adding another wrinkle to an already fragile picture.

It’s becoming harder to ignore the flashing red lights. The real fear? China could be heading toward its version of an economic twilight, much like Japan’s prolonged stagnation in the '90s, but with an even grander stage. While Japan’s stagnation was a slow-motion fade, China’s looming slowdown threatens to cast an even longer shadow over the global economy.

This isn’t just an economic hiccup—production is down, consumption is stalling, and even fixed asset investment, a traditional go-to for policy support, slows to a crawl. With credit markets staying slack, the data all but scream that the road ahead looks bleak unless the fiscal stimulus gets cranked up significantly.

The drums of a deepening economic slowdown are beating louder, and it’s time for China’s leadership to decide whether to step up or risk sliding further into stagnation.

China’s economy isn’t just resting; it’s in a full-on comatose state, with consumer demand gridlocked. Rate cuts from the People’s Bank of China (PBoC) are akin to trying to bail out a sinking ship with a teacup—the real issue isn't the price of borrowing but the absence of appetite for credit. Businesses aren’t expanding, and consumers aren’t spending.

It’s like trying to spark a fire with drenched wood—the cheaper loans are there, but without the fuel of confidence, nothing's going to ignite. The PBoC can slash rates all it wants, but if no one’s biting, it’s little more than an exercise in futility.

Forex markets

The BOJ has been cautiously inching toward normalization, leaving negative rates in the rearview mirror. In July, they nudged rates up for only the second time since 2007, lifting the key lending rate to 0.25%. Yield curve control is old news, and they’re even scaling back JGB purchases. Inflation? It's still above target. Real incomes? Climbing for two months straight. So, while the BOJ isn’t sprinting, they’re far from done. Expect one more hike this year—probably December—with the yen set to slip below ¥140 by year’s end.

In the FX market, the yen is the only game in town. As the BOJ tightens policy against the backdrop of the Fed on the cusp of an aggressive rate cut cycle, the yen is on the brink of a major strengthening cycle. Indeed, the yen is gearing up for a serious rally, and it’s just begun.