Two weeks
ago, the Federal Reserve (Fed) began a widely anticipated cycle of interest
rate cuts. As a result, the US dollar exchange rate fell to its lowest level
since July 2023. Moreover, the USD recorded its worst quarter in two years,
losing particularly strongly against the yen. Due to the narrowing interest
rate differential between the US and Japan, the $4 billion “carry
trade” is starting to fade.

Federal Reserve Slashes Rates: Impact on Dollar
Exchange Rate and Forex Market

On August
18, the US Fed cut its benchmark interest rate by half a percentage point, the
first time in four years. With this move, Federal Reserve Chairman Jerome
Powell signaled the beginning of a new cycle of interest rate cuts.

The
decision came after two years of aggressive rate hikes aimed at curbing rampant
inflation. At one point, inflation reached 7%, but has now fallen to around
2.2%. The Fed also managed to stabilize the unemployment rate and GDP, which
encouraged the Federal Open Market Committee (FOMC) to initiate a new easing
cycle.

“In
the current environment, there is uncertainty over whether the Federal Reserve
will cut rates for a positive reason: success in controlling inflation, or for
a more concerning one: rising economic risks,” commented Jon DuPrau,
Managing Partner at SuperDex. “This distinction is crucial because the
impact of Fed rate cuts on markets is heavily influenced by the broader
economic context.”

In
anticipation of the cuts, the US dollar exchange rate had already been
weakening. It reached its peak against major currencies in the second half of
2022 and has been on a downward trend since then. The latest leg of this
decline began in June 2024 and continues to this day. As a result, the dollar
index DXY, which measures the strength of the USD against major currencies such
as the euro, pound, and yen, has fallen to fourteen-month lows.

Interestingly,
analysts are convinced that this is just the beginning of the US dollar’s
depreciation. For example, Goldman Sachs in its latest forecast assumes that it
will soon reach more than three-year lows. This is expected to be particularly
noticeable against the British pound, which the banking giant predicts will
reach 1.40 next year. Currently, one pound buys 1.33 dollars.

The Fed’s
decision affected not only currency exchange rates and their volatility but
also other instruments and investor behavior. Broker representatives noticed a
significant increase in trading activity at the time of the US rate cut.

Currency Market
Volatility: Spreads Widen on Major Pairs and Indices

The
volatility range of major financial instruments on September 18 was
significantly higher than the average on other days. The EUR/USD currency pair
fell and rose within a range of more than 0.8% that day, reacting to both the
decision and the subsequent press conference with Powell.

“It’s
not surprising that such an event attracted increased investor interest, as the
Fed’s decision was anticipated by the market,” commented Marek Nita, Head
of OTC Market at XTB. “We noticed a significant increase in interest among
both logged-in users and those active during the announcement of the decision,
even compared to previous US interest rate decisions.”

Another
European broker, Mind Money, also noticed a widening of spreads. According to
its CEO, Julia Khandoshko, the differences between USD and EUR increased, but
nothing extraordinary was observed.

“Currency
spread USD/EUR has widened, but within the bounds of decency and market
expectations—no sudden and unexpected movements,” commented Khandoshko.

As Nita
adds, investors this time were interested not only in FX CFDs but also in other
instruments. Stock indices, S&P 500 and Nasdaq 100, as well as gold
contracts, attracted much more investor attention. Gold tested new historical
highs at $2,600 per ounce, after previously testing lows below $2,550.

“Interestingly,
in Europe and LATAM, activity on the mentioned indices prevailed, while in the
MENA and Asia regions, CFD contracts on gold were the most popular,” added
Nita.

We also
can’t ignore what happened with the yen, especially since the massive yen
“carry trade” is becoming less attractive.

$4 Billion Yen Carry Trade
Unwinds: Implications for Global Currency Markets

In July,
when the dollar was much stronger, the yen reached historical lows, with the
dollar-to-yen exchange rate at 162. However, in July, the Bank of Japan
surprised everyone by raising interest rates for the second time since 2007,
which led to a strong upward correction in the JPY.

“The
impact on the currency pair USD/JPY was not the consequence of the Fed’s
decision, but the result of the actions of the Bank of Japan. The Fed’s rate
cut affected the market in the expected way. But Japan’s rate increase really
surprised everyone. In this regard, the Fed acts predictably,” added
Khandoshko.

Meanwhile,
voices intensified that the Fed might cut rates by 50 instead of 25 basis
points (which it indeed did). Growing differences between rate expectations in
the US and Japan pushed USD/JPY lower and lower, ultimately bringing the
currency pair to 140.00, the lowest level in 14 months. In a relatively short
period, the dollar lost 14% against the Japanese yen, which reduces concerns
about carry trading.

“The
Fed lowering the USD interest rate by 50 means that carry trades are less
attractive and if investors think that will continue then you will see USD
under pressure,” Drew Niv, the CEO of TraderTools. “Since carry trade
is a huge motivation in institutional space this is the biggest factor in USD
movements. Obviously markets have anticipated this ahead of time so moves
happen usually before decisions but now it’s why the big economic releases move
markets.”

In the
first eight months of 2024, Japanese investors purchased a net JPY28 trillion
($192 billion) of domestic government bonds, marking the largest such
investment in at least 14 years. Concurrently, their acquisitions of foreign
bonds nearly halved to JPY7.7 trillion, while investments in overseas equities
remained below JPY1 trillion.

This shift
comes as the interest rate gap between Japan and other countries narrows,
making domestic investments increasingly attractive. The yield on 30-year
Japanese government bonds has risen about 40 basis points to over 2% this year,
approaching levels that major insurers consider appealing for increased local
debt holdings.

The
potential impact of this trend is substantial, given that Japanese investors
hold approximately $4.4 trillion in overseas assets – a sum larger than India’s
entire economy. They are the largest foreign holders of U.S. government bonds
and own nearly 10% of Australia’s debt.

Despite
these risks, some experts believe the transition may be smoother than initially
feared. Charu Chanana, a global markets strategist at Saxo Markets, commented
for Bloomberg, “The Fed’s commitment to achieving a soft landing has
reduced the odds of a recession. This means future repatriation may not
be as abrupt.”

FAQ: US Dollar, Fed Rates,
and Carry Trade

What caused the recent
decline in the US dollar?

The Federal Reserve’s decision to cut interest rates primarily triggered the decline of the US dollar. This move, which marked the beginning of a new easing
cycle, led to the dollar falling to its lowest levels since July 2023.

What is a carry trade?

A carry
trade is an investment strategy where traders borrow money in a
low-interest-rate currency and invest it in higher-yielding assets or
currencies. The goal is to profit from the interest rate differential while
hoping for favorable exchange rate movements.

How has the yen carry
trade been affected?

The $4
billion yen carry trade has been significantly impacted. As the interest rate
gap between Japan and other countries narrows, this strategy is becoming less
attractive. The dollar has lost 14% against the yen in a relatively short
period, reducing the appeal of yen-based carry trades.

What’s the outlook for the
US dollar?

Analysts
predict further depreciation of the US dollar. Goldman Sachs forecasts that the
dollar will reach more than three-year lows, particularly against currencies
like the British pound.