The market is digesting Powell's speech! The US dollar may become the preferred currency for carry trades

Now that Powell has made it clear that he will lower interest rates next month, bond traders are focusing on the size of the first rate cut and the future easing path.

Powell said last Friday that it is time for the Fed to lower the benchmark interest rate from its 20-year high, this is his clearest signal to date, indicating that the long-awaited rate cut is imminent.

Although Powell did not provide specific guidance on the size of the rate cut or the future easing path, he pointed out progress on inflation and stated that officials will closely monitor the health of the labor market as a guide to policy direction.

Jack McIntyre, portfolio manager at Brandywine Global Investment Management, said, "The market needs to digest this speech and remind itself that the Fed still relies on data **."

However, this was before the Middle East conflict erupted, with Israel attacking targets in southern Lebanon controlled by Hezbollah, the Iran-backed militant group claiming this was a preliminary response to its military leader being killed last month.

This turmoil may complicate the strategies of traders when Asian markets reopen on Monday, especially in terms of demand for safe-haven assets such as US bonds and the US dollar.

As of last Friday, bets on a significant rate cut next time were already evident. Traders increased bets on a 50 basis point rate cut in September. And the weakening US dollar is becoming the preferred currency for a new round of so-called carry trades, which involve using borrowed funds for high-risk bets.

Powell said at Jackson Hole last Friday, "The direction is clear," but "the timing and pace of rate cuts will depend on upcoming data, evolving outlooks, and risk balances."

John Velis, FX and macro strategist at BNY Mellon, said this means that for September, "the debate between 25 basis points and 50 basis points is still ongoing."

Powell's comments make the next important US monthly jobs report particularly crucial, which will be released on September 6. Velis said recent job data has been below expectations, and if the next data is similar, "a 50 basis point rate cut may occur."

For the entire year 2024, swap contract rates linked to central bank policy meetings show a total of about 100 basis points of rate cuts. With only three Fed meetings left this year, traders believe there is a significant possibility that one of the rate cuts will be substantial.

Ahead of the August jobs data release next month, there will be a series of data to analyze next week, with a focus on the July Personal Consumption Expenditures Price Index (PCE), which is the Fed's preferred inflation gauge. Both the headline and core PCE year-on-year rates are expected to be slightly higher than June levels.

Regardless of the path of rate cuts, the shift to easing is seen as having a negative impact on the US dollar, making the dollar a potentially attractive currency for carry trades, where traders can borrow dollars to invest in higher-yielding currencies and assets. However, these trades rely on low volatility, especially in terms of financing currencies - if the conflict in the Middle East escalates, this may be called into question.

Calvin Yeoh, portfolio manager at Singapore hedge fund Blue Edge Advisors, likened it to after Powell's speech last Friday: "Asia and other emerging markets may see an open bar paid in dollars, with a choice of a carry trade drink or a risk cocktail, making sober people worry about tomorrow."

Global investors have been engaging in carry trades by borrowing yen to purchase high-yielding currency assets until the Bank of Japan raised interest rates for the second time this year on July 31. This triggered a surge in the yen, leading to the collapse of trades and causing a chain reaction in global markets.

Citi Group pointed out that the strategy has made a comeback, with investors using dollars instead of yen as the financing currency.

Shoki Omori, Chief Trading Strategist at Tokyo Mizuho Securities, said after Powell's speech last Friday: "When Asia starts trading, everyone will focus on the yen. Last Friday, the US dollar fell freely against the yen and other currencies like the Brazilian real - investors here may echo a view that undervalued currencies like the yen are ultimately worth buying, now that Powell has mentioned adjusting policies."

Hours before Powell's speech last Friday, comments from Bank of Japan Governor Haruhiko Kuroda had already boosted the yen, as he indicated that the Bank of Japan may continue to raise interest rates