In recent years, the prices of major domestic assets such as the stock and real estate markets have gradually declined. Many experts attribute this to the continuous interest rate hikes by the Federal Reserve, leading to capital flows towards the United States and consequently causing a decrease in domestic asset prices.

Recently, there has been widespread attention to the Federal Reserve's upcoming interest rate decision in mid-September, with hopes that the Fed will significantly cut interest rates to change the direction of international capital flows.

In fact, Federal Reserve Chairman Powell has already given a "hint" about rate cuts in his public speech in August, making it a "known" that the Fed will start cutting rates in mid-September. The only remaining suspense is the magnitude and continuity of the rate cuts.

Based on my observation of recent U.S. economic data and the Federal Reserve's response patterns, I personally believe that the interest rate cut in September will likely be 0.25%. The impact of this on the global market has already been digested, and it is expected that the global foreign exchange and stock markets will remain calm at that time.

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Domestic investors are more concerned about the impact of the U.S. dollar rate cut on domestic asset prices. There are some bold predictions that the Fed's rate cut may trigger a trillion-dollar capital inflow from China, thereby driving the yuan to appreciate by 10%. These inflows of capital will provide strong support for the domestic stock and real estate markets.

The argument is that as the expectation of the Fed's rate cut strengthens and the interest rate differential between China and the U.S. gradually narrows, the attractiveness of U.S. dollar assets will be greatly reduced; some Chinese companies may choose to exchange some or all of their U.S. dollar assets for yuan, triggering a trillion-dollar capital inflow and allocation; and international capital will also increase its allocation to Chinese assets due to the change in the interest rate differential between the yuan and the U.S. dollar.

Is this argument reliable?

01

First, let's look at how the Fed's rate cut will affect the future exchange rate trend of the yuan against the U.S. dollar.

1. The long-term exchange rate level of a currency is determined by "purchasing power parity."This is the fundamental principle taught by the Macroeconomics 101 course. The long-term strength or weakness of a country's or region's currency is determined by its purchasing power, which is common sense.

An extreme example is that the currencies of countries such as Venezuela, Zimbabwe, Turkey, and Argentina have been devalued over the long term due to uncontrolled inflation. Imagine that today's hundred dollars can afford a feast, but in a few days, the same hundred dollars won't even buy a loaf of bread. Who would want such a currency? The currencies of countries and regions with uncontrolled inflation are inevitably worthless.

Western developed countries like Europe, the United States, and Canada have kept inflation at a low level over the past 20 years, but there has been a significant change in recent years. Based on my recent personal experience, whether it's a coffee breakfast for the common people or meat, eggs, dairy, fruits, and vegetables in the supermarket, prices have risen noticeably. Current prices have increased by about 40% compared to 2019. The nearly uncontrollable rise in prices has forced central banks in Europe and America to continuously raise interest rates significantly since 2022 to suppress inflation.

Looking at the economic data from recent years, there is currently no domestic inflation, and the purchasing power of the renminbi has remained strong. Therefore, from the perspective of purchasing power, there is truly no basis for the long-term devaluation of the renminbi.

2. The mid-term exchange rate level is determined by the risk-free yield of the local currency.

The difference in economic cycles between domestic and overseas developed countries has led to the relative weakness of the renminbi against the US dollar in the past period.

After the pandemic, the economic rebound in European and American countries was strong, and the inflation pressure was huge, so central banks were forced to maintain interest rates at relatively high levels, continuing to implement tight monetary policies to suppress inflation.

Domestically, as our central bank continues to guide the downward trend of domestic interest rates to support the economy, the current risk-free yield of the renminbi is around 2% and tends to continue to decline. The yield on newly issued 50-year long-term government bonds is only 2.53%, and it is expected that interest rates will remain at a low level for the long term.

The Federal Reserve's interest rate level has been maintained at over 5% for more than a year, which means that the risk-free yield of the US dollar is around 5%, creating a significant interest rate differential against the renminbi. A high interest rate differential will attract funds to flow back to the United States, thereby increasing the mid-term depreciation pressure of the renminbi against the US dollar.

The expected reduction in interest rates by the Federal Reserve will reduce this pressure. However, it is also a highly probable trend that the interest rate level of the renminbi will continue to decline, and the current situation where the risk-free yield of the US dollar is much higher than that of the renminbi is not expected to change in the medium term. From the perspective of interest rate differentials, the US dollar still maintains a clear advantage over the renminbi.Therefore, from the perspective of the risk-free rate of return, it is likely that the US dollar will be stronger in the medium term.

3. The short-term trend of the exchange rate depends on the attitude of the authorities.

In the past, during several cycles of the RMB exchange rate depreciation, the People's Bank of China and the State Administration of Foreign Exchange have stated: "There is no basis for the RMB to depreciate," which is the well-known adage - "There is no depreciation basis for people."

Looking at the latest stance of our central bank, it is "a balanced stability at a reasonable level." This implies that the RMB exchange rate will be allowed to fluctuate within a reasonable range. As for what constitutes a reasonable level, that is a matter of personal opinion. In fact, the domestic central bank's intervention in the exchange rate in recent years has been "to act when necessary."

The latest data released by the State Administration of Foreign Exchange shows that China's foreign exchange reserves currently stand at over 3 trillion US dollars, while the scale of offshore RMB (CNH) that needs to be regulated through market transactions is estimated to be around 300 billion US dollars (2 trillion RMB) in the industry. Controlling the level of the exchange rate is an easy task. The much larger onshore RMB (CNY) is not freely convertible in the market, and the State Administration of Foreign Exchange has no difficulty in guiding the pricing of the RMB exchange rate.

In fact, a weaker RMB exchange rate has many benefits for the domestic economy: it alleviates the pressure of domestic asset bubbles, as the valuation of domestic assets priced in US dollars comes down, which is conducive to diluting the domestic real estate bubble and also attracts international investors to direct investment; RMB depreciation is beneficial in reducing the price of export products priced in US dollars, stimulating the economy by promoting exports; it is also beneficial in directly improving the profits of export enterprises... The saying "RMB depreciation, China may become the biggest winner" is not entirely unreasonable.

In summary, I believe that the Federal Reserve's interest rate cut will have a certain positive effect on the RMB exchange rate to a certain extent, but to expect the RMB to significantly strengthen against the US dollar, it is estimated that it will have to wait until the domestic economy fully recovers, inflation gradually picks up, and the central bank begins to raise interest rates.

02

Will the Federal Reserve's interest rate cut lead international capital to flow into domestic stock and real estate markets?

I believe that the flow of international capital will be based on the following considerations:1. High cost-performance ratio is the ultimate truth

In the stock market, the main investment targets such as companies with low valuations, high return on equity, and high cash dividend returns are all important parameters for a high cost-performance ratio. Currently, in the A-share and Hong Kong stock markets, which have been in a continuous slump for many years, there are indeed many such targets. Investors can look forward to recovering their costs in about ten years through the continuous dividends of listed companies.

Therefore, it is considered to have a high cost-performance ratio and is worth long-term allocation, without any problem.

In terms of the real estate market, although the housing prices in the first and second-tier cities in the country have been significantly adjusted, the rental return rate is still less than 2% based on the current price. Referring to the stock market's valuation standards, it is also more than 50 times the price-to-earnings ratio. Such a valuation level is like fishing in the air to attract the participation of international capital.

2. The confidence of investors is more important

It is an undeniable fact that the domestic economy has entered a deep adjustment period after reaching the peak of the cycle. Even people who never look at the stock market can feel the chill from the fundamentals, such as the continuous downturn in consumption, the weak job market, and the decline in the price index.

The problem is that everyone is uncertain about how long the adjustment will last. On the policy side, there is no strong support measure (such as a significant interest rate cut, issuing cash consumption vouchers to residents, etc.).

There is a classic saying: Confidence is more important than gold. I believe that if there is a clear policy shift in the near future, it will be conducive to restoring the confidence of international investors to reallocate Chinese assets. For details, please refer to my previous article "When will the stock market bottom out?"

03

The capital market is weak, and the real estate market is also adjusting. How should investors respond?For the average citizen, the depreciation of the domestic currency manifests as a decrease in its international purchasing power. Holding a portion of foreign currency assets through various legal means can hedge this risk. At the same time, investing in financial products that are denominated in foreign investments can enhance the potential returns due to the weakening of the domestic currency.

For the vast majority of ordinary domestic investors, directly holding a portion of international currencies that are expected to remain strong in the future is also a quite suitable option. For instance, the US dollar, being the most widely accepted currency internationally, also offers the richest array of investment instruments. Following the old adage of "not putting all your eggs in one basket," it is essential to diversify one's foreign exchange asset allocation.

Another currency worth considering for allocation is the Japanese yen. After significant devaluation in recent years, the yen has become very strong in terms of purchasing power. From a cost-effectiveness perspective, the yen is very worthy of allocation. Moreover, due to the rapid narrowing of the interest rate differential caused by the US dollar's interest rate cuts and the yen's interest rate hikes, the yen's strengthening trend has just begun to form.

According to market principles: trends are not easy to form, and once a trend is established, it is even more difficult to reverse. This applies to the real estate market, stock market, foreign exchange market, and so on.

In terms of domestic asset allocation, due to expectations of further interest rate declines, high-credit fixed-income instruments, such as long-term government bonds, have become very scarce and often have to be purchased at a premium in the secondary market, making their long-term cost-effectiveness less attractive.

For those planning long-term investments, there are many excellent companies in the stock market with dividend yields ranging from 3% to 6%. The prerequisite is that investors must have the ability to identify truly outstanding listed companies and be able to bear the risks of price fluctuations.

This article represents the author's views.