Market Faces Dilemma: 50 Basis Point Rate Cut vs. Economic Recovery

The global financial market is currently grappling with two contrasting narratives: the expectation of a 50 basis point interest rate cut by the Federal Reserve in September and the anticipation of a global economic recovery. These two expectations are mutually exclusive, and the upcoming U.S. non-farm payroll report, scheduled for release on September 5, is expected to be the decisive factor in determining which narrative will prevail.

Market analysts have observed a contradictory behavior in the market. While there is a 6% probability of a 50 basis point rate cut by the Federal Reserve in September, as indicated by the CME FedWatch Tool, there are also calls for such a cut from influential figures. This expectation has led to a weakening of the U.S. dollar. However, the U.S. stock market has been setting new historical highs for two consecutive days, with a broad-based recovery evident across various sectors, including small-cap stocks, consumer-related sectors, and emerging market equities. This suggests that market participants are increasingly optimistic about macroeconomic improvements.

This dual scenario, where investors are betting on both monetary easing and economic growth, has created uncertainty in the market. The pricing of a significant rate cut by the market appears to be more of an insurance policy against potential downside risks in economic data. The outcome of the economic recovery narrative versus the recession concerns leading to rate cut expectations will likely be revealed soon.

The core of the report is that the market cannot indefinitely maintain this dual narrative. The upcoming U.S. non-farm payroll report will force investors to choose between the "rate cut" and "recovery" scenarios, potentially triggering significant capital shifts. If the employment data is weaker than expected, the narrative of global economic recovery will lose credibility. In this case, expectations for a significant rate cut by the Federal Reserve will be reinforced, leading to a rapid outflow of funds from cyclical assets into bonds and technology stocks, which may once again become the leading sectors in the market. Conversely, if the data confirms a strong economy, expectations for an "excessive" rate cut will quickly dissipate. In this scenario, funds may shift from technology stocks, which have seen substantial gains, to cyclical stocks that are more closely tied to economic recovery.

The previous non-farm payroll report was particularly dismal, with the U.S. adding only 73,000 jobs in July, far below expectations, and the previous two months' data being revised down by 258,000. For global investors, the report highlights potential opportunities in the Japanese market. The analysis reveals a high correlation between the TOPIX index, priced in U.S. dollars, and the U.S. Russell 2000 small-cap index. The Russell 2000 index has reached a new high for the year, approaching its historical peak, driven by both liquidity easing and expectations of macroeconomic improvement. Therefore, if the global economic recovery narrative ultimately prevails, the Japanese stock market is likely to be a strong-performing asset. Additionally, Japanese technology stocks, which have stronger cyclical properties and relatively lower valuations compared to U.S. technology stocks, may see their valuation gaps narrowed in an environment of global economic recovery. In such a scenario, the Japanese bond market may experience a "bear flattening" trend.