What increasing US interest rates mean for other markets (illustrated by the examples of China & Japan)

Anno Domini 2022. The Federal Reserve signaled in March six more interest rate increases for the remainder of 2022 after it raised rates by 25 basis points to range between 0.25% and 0.50%. The FED's median federal funds rate projection was raised to 1.9% for 2022, which means the central bank can hike rates by 25 basis points in each of the remaining six meetings this year. The previous projection in December 2021 was less than half 0.9% for the year.

What effect does this policy have onto other markets?

In order to understand what effect exactly this policy has onto other markets (frontier,-emerging,-and developed markets), we need to understand what carry trades are, afterwards we can understand the direct and implied effects.

What are carry trades?

A carry trade is a trading strategy?that involves borrowing at a low interest rate?and investing in an?asset that provides a higher rate of return. A carry trade is typically based on borrowing in a low-interest rate currency (here e.g. Japanese Yen) and converting the borrowed amount into another currency (in our case US dollars). Generally, the proceeds would be deposited in the second currency if it offers a higher interest rate (US dollars). This can also apply to other currencies (non-typical carry trades), e.g. when the future economic outlook changes or the second currency does not come with capital controls/is perceived easier to transfer and allocate (here the US dollar vs. Chinese Yuan). As profit-generating assets, in many cases, real estate or regular treasury bonds are used, as they are broadly considered "safe assets".

What are the long-term effects?

"A picture says more than a thousand words." In our case we are talking about pictures.

Since the annoucement from the FED in March, the Yen has collapsed against the US dollar (in less than six weeks) to a 20-year low. The Bank of Japan has contacted the Federal Reserve, asking for a common intervention in the exchange markets, which was ignored by the FED.

As a second example here the Chinese Yuan.

The Chinese Yuan has lost more than 7% of its value, also in the timespan of about six weeks. These are incredible numbers, especially considering that fiat currencies are supposed to be somewhat stable and not significantly moving against each other, at least not in the short-to medium term.

So what are going to be the results?

It seems that in all (especially highly leveraged markets), increasing US interest rates will result in:

1. Medium-and long-term higher inflation (as imports such as oil etc. are paid in US dollars) = printing more of local currency to balance exchange market imbalance
2. More countries continuing to look for alternatives to the US Dollar to trade major imports (which are mostly commodities) in.
3. Higher inflation in combination with low/negative economic growth will certainly enable further stagflationary/deflationary environments in the long-run. Time will tell.

Sources

https://www.aa.com.tr/en/economy/us-federal-reserve-signals-6-more-interest-rate-hikes-for-2022/2537570#:~:text=The%20Fed's%20median%20federal%20funds,was%200.9%25%20for%20the%20year.

https://tradingeconomics.com/japan/currency

https://www.afr.com/markets/currencies/dovish-boj-triggers-currency-market-chaos-20220429-p5ah5i

https://tradingeconomics.com/china/currency