Return of the Carry Trade?

After the Fed cut its benchmark lending rate by 75 basis points last week, the Dollar immediately rallied 2.5% against the Japanese Yen, marking its highest daily rise in nine years. Some analysts are at a loss to explain this phenomenon, since a narrower interest rate differential should have produced the opposite effect. Perhaps, the answer can be found in the carry trade, whereby investors sell Yen in favor of higher-yielding currencies. Support for the carry trade typically moves inversely with volatility. For example, when risk aversion rises due to economic uncertainty, investors typically unwind their carry trade positions. With the Fed rate cut last week, however, risk aversion actually fell, and the S&P 500 Index surged. By no coincidence, the Yen fell. Reuters reports:

As U.S. stocks rallied, with investors willing to take on more risk, the dollar recouped some of Monday's sharp losses versus the low-yielding yen.