Powell "hints" at rate cut, will the market shift to "USD carry trades"?

As Federal Reserve Chairman Powell has hinted at a rate cut next month, bond traders have shifted their focus to the magnitude of the first rate cut and the future easing path. Powell stated last Friday that the "time has come" for the Fed to lower the benchmark interest rate from its 20-year high, marking his clearest signal yet that the long-awaited rate cut is imminent. Regardless of the trajectory of the rate cut, the shift towards easing is seen as unfavorable for the US dollar, making it a potentially attractive currency for carry trade.

Fed Rate Cut is Certain, Market Focus Shifts to Pace of Rate Cuts

By last Friday, the next major bet on rate cuts had become the focus. Traders have increased their bets on a 50 basis point rate cut in September. The weakening US dollar is becoming the preferred currency for a new wave of carry trades, involving high-risk bets using borrowed money.

Powell stated at Jackson Hole last Friday, "The direction forward is clear," but "the timing and pace of rate cuts will depend on upcoming data, evolving outlook, and risk balance." John Velis, FX and macro strategist at BNY Mellon, said this means for September, "whether it's 25 basis points or 50 basis points is still an open question."

Powell's remarks imply that the US monthly nonfarm payrolls report scheduled for release on September 6th is crucial. Velis stated that recent employment data has been below expectations, and if the next set of data follows suit, "then 50 basis points might be on the table."

Interest rate swap contracts linked to Fed policy meetings throughout 2024 show that the market is betting on a total of 100 basis points in rate cuts this year. With only three Fed meetings left this year, traders believe there is a high likelihood of a significant rate cut - a 50 basis point reduction, while the Fed's normal rate cut size is 25 basis points.

Bloomberg strategist Cameron Crise said, "Powell ultimately told us some things we already knew, albeit perhaps more forcefully than some of his colleagues. All of this will focus attention entirely on the next employment data in a few weeks, and of course, the subsequent Federal Open Market Committee (FOMC) statement next month."

Ahead of the release of the August nonfarm payrolls data in the US, a series of data will be released this week for market analysis. The July PCE price index will be released on August 30th - the core PCE price index is the Fed's favored inflation gauge. Both the overall and core PCE price index year-on-year rates are expected to be slightly higher than June levels.

Dovish Expectations Ignite the Market

Although Powell did not specify the extent of rate cuts or the easing path, he pointed out progress on inflation and stated that Fed officials will closely monitor the health of the job market as a policy guide. His remarks last Friday pushed down U.S. Treasury yields and the U.S. dollar, boosting the U.S. stock market and giving investors a "green light" for risk appetite.

After Powell's speech, U.S. Treasury prices rose, with yields on all maturities falling. The yield on the benchmark 10-year U.S. Treasury closed at 3.8% on the day, down 8 basis points last week. Bloomberg Index shows that the yield on U.S. government bonds this month is 1.44%.

U.S. Treasuries are expected to achieve a fourth consecutive month of gains, the longest positive streak in three years. The prospect of the Fed lowering policy rates has led the S&P 500 index to rise 18% year-to-date in 2024. Since the end of June, the Bloomberg Dollar Index has fallen by over 4%. The ongoing escalation of geopolitical risks in the Middle East is also expected to boost demand for U.S. Treasuries as a safe haven, but risk aversion may lead the S&P 500 index to give up gains and boost the U.S. dollar.

However, Jack McIntyre, portfolio manager at Brandywine Global Investment Management, stated: "The market needs to digest this speech and remind itself that they - and the Fed - still rely on data. Although Powell's tone is mild, the data must now support it."

Moreover, after Powell's speech, tensions in the Middle East conflict escalated, with Israel attacking Hezbollah positions in southern Lebanon, and Iran-backed militant groups initiating what they called a preliminary retaliation for the killing of their military leader last month. This turmoil may disrupt rate-cut trading plans when Asian markets reopen on Monday, especially in terms of demand for safe-haven assets such as U.S. Treasuries and the U.S. dollar.

Arbitrage Trading Shifts to the U.S. Dollar?

Regardless of the rate-cut trajectory, a shift towards rate cuts is seen as unfavorable for the U.S. dollar, making it a potentially attractive currency for arbitrage trading, where traders can borrow in dollars and invest in higher-yielding currencies and assets. However, for these trades to be successful, they rely on low volatility, especially in the low volatility of funding currencies - a point that may be questioned if the Middle East conflict escalates.

Prior to the Bank of Japan's second rate hike of the year on July 31, global investors had been heavily engaged in carry trades, borrowing in yen to purchase higher-yielding currency assets. However, the rate hike led to a sharp appreciation of the yen, causing the trades to break down and triggering turmoil in global markets. Citigroup previously stated that this strategy is making a comeback, with trading funds shifting from yen to dollars Citigroup's global head of forex quantitative investment solutions, Kristjan Kasikov, said in an interview: "We have seen that the sentiment towards the US dollar is becoming more pessimistic. People speculate that the environment of interest rate cuts is fueling risk appetite."

This marks a turning point since the global economic recession earlier this month, when arbitrage trading took a heavy hit. In carry trades, investors borrow currencies with lower interest rates and invest the proceeds in higher-risk assets with higher interest rates. Kasikov mentioned that considering the outlook for interest rate differentials between the US and Japan, hedge funds using this strategy are now choosing the dollar as the funding currency instead of the yen.

Data from the US Commodity Futures Trading Commission shows that hedge funds have been bearish on the yen in the futures and options markets since 2021. As the Bank of Japan's actions indicate a historic shift in interest rate policy, these hedge funds have started to turn bullish on the yen after the carry trades unwound.

However, Kasikov noted that Citigroup expects the window of opportunity for profitable global arbitrage trading to be short-lived, as the turmoil surrounding the US presidential election could lead to another spike in volatility. He pointed out: "We have been concerned about forex carry trades for some time. The US election and political agenda will bring more volatility to the market, and risk aversion sentiment will also have an impact."

Shoki Omori, chief strategist at Tokyo Mizuho Securities, said on Friday after Powell's speech: "When Asia starts trading on Monday, all eyes will be on the yen. From the yen to the Brazilian real, the exchange rates of all currencies against the dollar are plummeting in a straight line. On Friday, investors may agree with the view that currencies like the yen, which have been hit hard, are ultimately worth buying against the dollar. Powell now says it's time to adjust policy."

In the late trading session in the New York forex market last Friday, the dollar was quoted at 144.39 against the yen, with the yen rate rising by 0.7% on the day and accumulating a 2.2% increase for the week. Before Powell's speech on Friday, the yen had already strengthened, as Bank of Japan Governor Haruhiko Kuroda stated a few hours before Powell's remarks that the Bank of Japan may continue to raise interest rates