Monday's global stock market sell-off led to calls for the Federal Reserve to step in , but that could prove to be even more trouble for investors. This sell-off is not being driven banking crisis, and an emergency rate cut by the Fed may hurt more than it helps, said Lawrence McDonald, a bestselling author and market risk expert. "If they do that, they weaken the dollar, they actually strengthen the yen, and this whole carry trade gets worse," McDonald said.
Currencies often strengthen against their counterparts when their central bank hikes rates, and vice versa. JPY= 5D mountain The dollar fell against the Japanese yen on Monday. The " carry trade " mentioned by McDonald and others as a key reason for this sell-off is related to interest rates in Japan.
Central banks in the United States and other developed markets have hiked interest rates aggressively in the post-pandemic period to fight inflation. But in Japan, where inflation was more benign and the government has long struggled to kickstart economic growth, rates stayed near zero. As a result, hedge funds and other investors were able to borrow yen cheaply and then buy assets around the globe.
This trade worked as long as the gap between the Bank of Japan and other central banks stayed wide and the yen was weakening against other currencies, such as the dollar. And it was working up until late July, when the Bank of Japan hiked its benchmark interest rate and said it would tap the brakes on its bond-buying program. That helped boost the yen and spark the unwind of the carry trade.
And even with the U.S. market sell-off stabilizing some on Monday afternoon, it could still be risky for the Fed to cut rates and potentially strengthen the yen, according to McDonald.
"When you have this type of a 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," McDonald said. If the Fed does act, using its balance sheet could make more sense than a rate cut, he added.
McDonald's books include "A Colossal Failure of Common Sense," about the downfall of Lehman Brothers, and " When Markets Speak ." He is also the author of the Bear Traps Report newsletter..
