To begin this week’s newsletter, we examine the Federal Reserve’s potential interest rate cuts, focusing on the consequences such cuts would have for the global economy. Then, we touch on the People’s Bank of China (PBOC), which is grappling with a potential bubble in the country’s bond market. We then move on to look at new threats on the horizon, from bioweapons to artificial intelligence (AI). We end this week’s newsletter by looking at the challenges that Mexico’s new president, Claudia Sheinbaum, must face upon taking office later this year.

Fed Rate Cuts and China’s Economic Response

Fed Cuts May Send $1 Trillion FX ‘Avalanche’ to China, Jen Says 

Ruth Carson and Anchalee Worrachate, Bloomberg

The Make-or-Break Moment That Will Determine the Economy’s Fate 

Nick Timiraos, Wall Street Journal

The Federal Reserve’s potential interest rate cuts could trigger significant shifts in the global economy, particularly between the U.S. and China. As U.S. rates decrease, the attractiveness of dollar-denominated assets may diminish, prompting Chinese firms to repatriate their substantial foreign exchange reserves—estimated by Stephen Jen, CEO of Eurizon SLJ Capital, to be as much as $1 trillion. This massive influx of capital back into China could lead to a notable appreciation of the yuan, potentially strengthening it by 5% to 10%. Such a shift could have profound implications, especially if the People’s Bank of China (PBOC) allows the yuan to rise without intervention, especially for Chinese exporters who benefit from a weaker yuan.

However, the broader economic landscape remains fraught with uncertainty. The Federal Reserve, under Chair Jerome Powell, is carefully navigating a precarious “soft landing” for the U.S. economy, aiming to lower inflation without triggering a recession. This delicate balancing act could either lead to a historic achievement for the Fed or result in an economic downturn if not managed correctly. The timing and magnitude of rate cuts are critical, as they could influence global markets, potentially causing a ripple effect similar to past financial crises. As the U.S. attempts to stabilize its economy, the interplay between American monetary policy and Chinese economic strategies will likely shape the future of international trade and finance.

PBOC’s Bond Market Dilemma

China central bank fears Silicon Valley Bank redux as yields sink

Noriyuki Doi, Nikkei

Chinese central bank crackdown shakes bond market

Wataru Suzuki and Echo Wong, Nikkei

The People’s Bank of China (PBOC) is currently grappling with the potential risks posed by a burgeoning bubble in the country’s government bond market. As long-term bond yields have sunk to near-record lows, banks, particularly in rural areas, are heavily investing in these bonds, seeking safe returns amidst a sluggish economy, a depressed real estate market, and a general distrust of the stock market. This has led to fears of a Silicon Valley Bank-style crisis, where a sharp rebound in yields could result in significant losses for these institutions. The PBOC has been proactive in addressing these concerns, issuing guidance to large state-owned banks to reduce their bond holdings and launching investigations into smaller rural banks suspected of manipulating bond prices. Despite these efforts, the central bank faces a challenging task in curbing the bond-buying frenzy while simultaneously trying to support the economy through loose monetary policy.

The PBOC’s attempts to stabilize the bond market have so far had limited success. While the central bank has engaged in various measures, including conducting additional market operations and signaling potential bond sales, bond yields have continued to fluctuate. The persistent demand for government bonds, driven by fears of economic stagnation and deflation, has kept prices high and yields low. The situation is further complicated by the lack of attractive investment alternatives, as weak stock and real estate markets push investors towards bonds. Analysts warn that unless the PBOC successfully balances its efforts to cool the bond market with its need to stimulate economic growth, the risk of a bubble burst remains, which could have significant repercussions for the broader financial system.

New Threats on the Horizon

The New Bioweapons: How Synthetic Biology Could Destabilize the World 

Roger Brent, T. Greg McKelvey, Jr., and Jason Matheny, Foreign Affairs

‘Never summon a power you can’t control’: Yuval Noah Harari on how AI could threaten democracy and divide the world

Yuval Noah Harari, The Guardian

The COVID-19 pandemic, serving as a global “penetration test,” exposed humanity’s vulnerabilities in managing infectious diseases, revealing that synthetic biology and artificial intelligence (AI) now enable the creation of highly effective and potentially catastrophic pathogens. As scientists continue to push the boundaries of molecular biology, the risk of a synthetic pathogen causing widespread harm becomes ever more plausible, highlighting the urgent need for enhanced global defenses and rapid response systems. Traditional methods of deterrence, such as those used during the Cold War, are inadequate for addressing the risks of biological warfare. Unlike nuclear threats, biological attacks can be launched covertly and without immediate attribution, making retaliation and deterrence far more complex. A multi-faceted approach to biodefense, including swift vaccine production, better protective equipment, and stricter regulation of biotechnologies, is required to counteract the growing threat of synthetic bioweapons.

The rapid development of AI also poses unprecedented risks to humanity, surpassing traditional dangers like nuclear weapons. Drawing on historical myths and cautionary tales, Harari argues that our pursuit of AI could lead to consequences we cannot control, echoing the lessons of Phaethon and Goethe’s apprentice. Unlike previous technologies, AI has the potential to operate autonomously and evolve in ways that humans cannot fully understand, making it a profound threat to democracy and global stability. The current global race to harness AI could exacerbate existing inequalities, with wealthy nations gaining disproportionate benefits while poorer countries fall further behind. Without global cooperation and regulation, AI could lead to catastrophic outcomes, potentially transforming geopolitical dynamics and endangering the future of human civilization. The threats posed by AI and synthetic bioweapons are significant, but the precautions and measures needed to prepare for and address these threats are within our reach. However, they require international cooperation because these threats are transnational and not confined to any single sovereign territory.

Sheinbaum’s Economic and Energy Challenges in Mexico

Investors panicked after Mexico’s election. Were they right? 

The Economist

Confused and dirty: Claudia Sheinbaum’s energy plan 

The Economist

Mexico’s President Bet Big on Oil. His Successor Will Be Stuck With the Tab.

Simon Romero, New York Times

As Claudia Sheinbaum prepares to take office as Mexico’s first woman president on October 1st, the nation faces a complex and daunting legacy left by her predecessor, Andrés Manuel López Obrador (AMLO). The economic landscape is marked by contrasting dynamics: while nearshoring driven by U.S.-China tensions offers growth prospects, AMLO’s tenure has been marred by low GDP growth, rising crime, and policies that deterred investment. These issues, coupled with a significant fiscal deficit and stagnant productivity, present a formidable challenge for Sheinbaum as she attempts to stimulate economic growth and address widespread insecurity. Her initial plans to tackle these challenges have been met with skepticism, raising concerns about her ability to effectively reverse AMLO’s policies and drive meaningful change.

Despite her strong environmental credentials and a background in energy engineering, Sheinbaum’s approach to energy policy reveals a commitment to continuing AMLO’s focus on state-controlled enterprises like Pemex and CFE. This stance is exemplified by the recent inauguration of a $16 billion oil refinery in Tabasco, underscoring Mexico’s persistent reliance on fossil fuels which will complicate Sheinbaum’s efforts to pivot towards renewable energy. Pemex, now the world’s most indebted oil company (nearly $100 million in total debt), faces severe financial strain and operational inefficiencies, limiting a country that depends on fossil fuels for 80% of its energy. Pemex’s struggles have resulted in a 45-year low in Mexican oil production. Meanwhile, blackouts across the country become more commonplace but the AMLO government continues to double down on the faltering industry. Sheinbaum’s support for controversial constitutional reforms that could undermine independent regulatory bodies further adds to investor uncertainty. Balancing the nation’s entrenched oil nationalism with the urgent need for a clean energy transition will be a critical and challenging aspect of Sheinbaum’s presidency.