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,” commented 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.