The implications of the Fed rate cut on A-shares and a discussion on cross-border capital flows

Introduction

At the Jackson Hole Symposium in August 2024, Powell delivered an important speech, where he announced:

1. The timing for policy adjustments has arrived; the timing and pace of rate cuts will depend on data, outlook, and the balance of risks;

_2. Not seeking or welcoming further cooling of the labor market; will make every effort to support a strong labor market, while making further progress in achieving price stability; the policy rate level provides "sufficient space" to address risks, including further adverse softness in the labor market.

This extremely dovish statement marks a complete turnaround in U.S. monetary policy, signaling the beginning of a rate-cutting cycle.

As a result, the U.S. dollar index plummeted significantly, depreciating by 0.82%. So, how does this affect China's risk assets? It effectively lowers the domestic risk-free rate.

In the article "The Essence of Risk-Free Rates and Their Suppression of Stock Valuation," we have discussed the issue of risk-free rates. In this article, we will further elaborate and discuss the issue of cross-border capital flows.

Risk-Free Rates Corresponding to Chinese Assets

Many stock investors make a common mistake: choosing the ten-year government bond rate as the risk-free rate. However, in actual investment, we have not observed such a movement pattern: as the ten-year government bond rate declines, the valuation of the CSI 300 Index rises.

As shown in the above chart, while the ten-year government bond rate fluctuates downward, the dynamic P/E ratio of the CSI 300 Index fluctuates significantly around 11.5.

So, why 11.5? We can think outside the box and make a new attempt.

If we use the U.S. risk-free rate - the Federal Funds Rate of 5.5%, plus a 3% risk premium, then the discount rate of the CSI 300 Index is 8.5%, corresponding to a P/E ratio of 11.76. This value is very close to the central value of 11.5.

Of course, this is not the only coincidence. We can also use this risk-free rate to calculate the valuation of Hong Kong stocks.

Since Hong Kong stocks are denominated in Hong Kong dollars (ps: equivalent to U.S. dollars), to convert it into Renminbi, we need to add a forward exchange, but now taking a long position in Renminbi forwards requires paying forward points, calculated at a cost of 3%.

Therefore, the discount rate of Hong Kong stocks = Risk-Free Rate + Risk Premium + Forward Cost. By inputting the data, we can calculate that the discount rate of Hong Kong stocks is 11.5%, corresponding to a P/E ratio of 8.69

Currently, the dynamic PE ratio of the Hang Seng Index is 8.9.

In fact, we can take a more interesting perspective on this valuation. After the CPI data landed in the US in July, the "Fed megaphone" came out to say that the data cleared the way for a rate cut in September.

Due to the clean debt of Hong Kong stocks and no redemption or liquidation issues like A-shares, investors can discount in advance at 11.25%. Coincidentally, the corresponding PE ratio is 8.88, a very auspicious number.

This is another coincidence.

In the domestic capital market, there is a saying: buy 30-year treasury bonds domestically and buy the Nasdaq index overseas.

By comparing the trends of the two, we can observe a kind of unexplained correlation. What is the underlying mechanism behind the two?

Since the US determines China's risk-free rate, we naturally have a speculation: China determines the US risk-free rate.

As shown in the above figure, our policy rate is 1.7%, the US is a developed country, and the risk premium is calculated at 2%. Therefore, the discount rate of the S&P 500 index is 3.7%, and the corresponding dynamic PE ratio is 27.02.

As shown in the above figure, the dynamic PE ratio of the S&P 500 index is currently at 27.2, which is really too coincidental.

Global Capital Flow Hypothesis

The above coincidences reveal a clue to us: the Fed cuts interest rates on Chinese risk assets, and the Chinese central bank cuts interest rates on US risk assets.

This is inconsistent with the model we learned in textbooks, which is a closed model. It believes that,

The central bank determines the risk-free rate of the country, and the discount rate of domestic risk assets is the risk-free rate plus the risk premium.

This is a closed model, but the real world is an open model. Various signs suggest that once the model is transformed into an open model, the pricing anchor goes to the other side. In other words, once cross-border capital flows become a significant factor, the incremental funds in the country do not come from the domestic central bank, but from the other side.

Therefore, the risk-free rate of A-shares is the federal funds rate.

Similarly, the risk-free rate of US stocks is the one-year deposit rate in China.

There is nothing strange about this. The traditional model simply assumes that the incremental funds for domestic risk assets come from the domestic central bank, while the open model assumes that the incremental funds for domestic risk assets come from the central bank across the border.

The World as a Whole

We have always had a mistaken intuition: China has M2 of 300 trillion, and this currency will provide strong support for domestic asset prices.

However, once we view the entire world as a whole, we will not think this way.

Who says that China's M2 can only support RMB assets ??

This is a subtle but deadly mistake. If a significant portion of this 300 trillion M2, through some mechanism, supports US assets, then all the puzzling phenomena can be easily explained.

Subconsciously, you think that different parts of the world are relatively isolated, but in reality, they are closely interconnected.

Furthermore, many people are amazed by a phenomenon: why are the yields on ten-year government bonds so low, yet the Chinese government has not issued a large amount of government bonds? Is there a cheaper way to finance?

Indeed there is.

The current cheapest way to finance is to

borrow floating-rate loans in US dollars while converting them into RMB for use in China

.

Assuming an observation period of 3 years, with an average loan cost of 3%, during an interest rate cut cycle, the US dollar will depreciate significantly. Assuming a 21% depreciation over 3 years,

the actual loan cost is -4%

. This cost is much cheaper than the 2% yield on ten-year government bonds. Therefore, if China is seen as a closed economic entity, a financing cost of 2% is considered cheap; conversely, if China is viewed as an open economic entity, we must make good use of

the financing convenience brought about by RMB appreciation

.

As shown in the above figure, RMB appreciation will bring two effects:

First, a short squeeze effect

, where investors who previously borrowed RMB to exchange for US dollars face "margin calls," causing their financing costs to rise sharply and capital to flow back;

Second, an interest rate reduction effect

, where borrowing US dollars to exchange for RMB becomes extremely attractive, leading to a significant reduction in financing costs and external capital inflows

Therefore, in today's era of global capitalization, the domestic static risk-free interest rate is often not the most crucial rate. What truly matters is the exchange rate, and we need to determine the position of the US dollar cycle.

True or False Interest Rate Cuts

Once the dimension of cross-border financing is introduced, interest rate analysis becomes extremely complex. We need to consider two interest rates simultaneously, 1. domestic interest rate; 2. cross-border interest rate.

As shown in the above figure, cross-border interest rate refers to the comprehensive cost of borrowing foreign currency to use domestically. Therefore, the level of cross-border interest rate heavily depends on the exchange rate and will be significantly amplified by exchange rate fluctuations.

Furthermore, since domestic interest rates and cross-border interest rates are generally inversely related, when considering the comprehensive financing cost domestically, we need to evaluate the size of cross-border capital flows.

If cross-border capital flows are significant, then lowering domestic interest rates is actually "raising rates" because cross-border interest rates will increase; if cross-border capital flows are small, then lowering domestic interest rates is indeed "cutting rates".

In fact, the analysis in the market has always lacked an international perspective, which is why there is confusion as to "why the one-year deposit rate has been declining, yet the economy has not shown signs of improvement".

People naturally made a hasty assumption:

Cross-border capital flows are small, and the impact of cross-border interest rates is relatively minor.

Conclusion

In the article "Why is the Exchange Rate the Most Important Monetary Policy Variable?", we told a story:

1. There is only one currency in the world - the US dollar;

2. Other currencies are just a layer of skin on top of the US dollar;

Therefore, how central banks around the world wear this "clothing" becomes extremely important, which is why I say, the exchange rate is the most important monetary policy variable.

In this article, we go further to ask, who is this "clothing" worn for,

Why do those spectators value this outfit so much. The answer behind it is quite simple:

1. Exchange rates will affect cross-border interest rates; 2. The volatility of cross-border interest rates is much higher than that of domestic interest rates.

Many people always talk about decoupling between China and the US, which I honestly find quite superficial. The capital markets tell us that the cooperation between China and the US is becoming closer and closer, to the point where they now mutually determine the risk-free interest rate.

Of course, you can think of all this as a coincidence.

In fact, the A-share market is much more "international" than we imagine, with incremental funds coming from foreign investors, and pricing anchors overseas. However, many domestic investors are trapped in an information bubble, either focusing on their own numerator or their "false denominator", with their perspectives confined within the domestic market

Take a break and look across the other shore.

ps: Data from Wind, image from the internet