Investing.com -- If the Federal Reserve cuts aggressively next week at a time when economic growth appears to be intact, then it could backfire, spooking rather than supporting the market, BCA Research said in a recent note.
A bigger rate cut just as economic growth appears to be on a stable footing, would spark speculation about the economy, BCA said, but a "much more important reason why aggressive dovishness would backfire ... is the yen carry trade."
The yen carry trade has been popular for years as traders borrowed yen at low rates to fund trades such as stocks with higher return. The key crux of this trade was faith the Bank of Japan would remain ultra dovish on monetary policy amid a prolonged struggle with deflation and sluggish economic growth.
A further unwinding of the yen carry trade, which is closely tied to tech valuations, BCA argues, would leave a big dent in big tech, leading to calls for further aggressive cuts, which could likely "guarantee the very recession that the Fed is trying to stave off."
BCA believes that big tech and the yen shares a "reflexive" relationship. The steady rise in big tech has made it a 'go to' destination for the yen carry trade, while "the appreciation in tech valuations likely required leverage from borrowing yen at near-zero interest rates."
Aggressive rate cutting would hurt the dollar, driving up the yen, BCA says, causing a "further downdraft in US tech stock valuations versus bonds."
A recession isn't as far fetched as some believe as bond traders already appear to be positioning for a soft landing.
The US interest rate curve is already pricing in a "full-blown recession in the next six months, with 170 basis points of rate cuts discounted in the February 2025 Fed funds contract," BCA said.
"This implies at least two half-point rate cuts in the next five policy meetings, a pace typically seen only during recessions," it added.
The Fed kicks off its two meeting on Sept. 17, and is widely expected to deliver a 25 bps rate cut.