GBP/JPY, AUD/JPY: Carry trades flock to FX outperformers as hard landing risks recede

• Fears surrounding a US hard economic landing have receded over the past month
• Markets appear comfortable with further modest tightening from the BOJ over the next year
• This macro backdrop has allowed yen carry trades to be reestablished
• GBP/JPY breaks above 200DMA, AUD/JPY next?
• US jobs data incredibly important for carry trades to continue working

Overview

With market concerns surrounding a hard economic landing in the United States diminishing over the past month, it has allowed Japanese yen carry trades to be reestablished, seeing capital flow towards parts of the world that are currently outperforming. The UK is one place that fits that bill, seeing GBP/JPY take out an important resistance level on the charts. Its breakout may act as a lead indicator for a similar move in AUD/JPY.

US data resilience returns

Around a month ago, markets were shaken by a raft of weak US economic data that saw hard landing fears escalate sharply, leading to substantial declines in riskier asset classes, sharply lower US Treasury yields and sizeable unwind in carry trades involving the Japanese yen. It was wild, rivaling anything seen during the pandemic plunge of 2020 or GFC.

However, since July’s weak nonfarm payrolls report, the dataflow out of the US has been solid if not spectacular, seeing pricing for Fed rate cuts in 2024 trimmed to 100 basis points, contributing to a steady uplift in US Treasury yields across the curve, widening the gap with equivalent Japanese bonds once again. As such, one of the necessary ingredients for carry trades has been re-established – widening yield differentials.

BOJ expected hikes not creating panic

While it was not the primary cause of what happened in early August in my view, the decision from the Bank of Japan to deliver a larger-than-expected rate hike in July contributed to the carry trade unwind, increasing the cost to borrow in yen to funnel into other higher-yielding assets. You can see the spike in Japan one-year overnight index swaps (OIS) pricing immediately following the BOJ’s meeting, signaling market expectations for overnight interest rates in Japan over the next year jumped to levels not seen since the onset of the GFC.

However, while the one-year OIS rate of 0.3238% implies around another 20 basis points of hikes are expected from the BOJ over the next year, the behavior in markets in August suggests traders are comfortable with this view given expectations for stronger returns elsewhere.

Source: Refinitiv

UK economy emerges from doldrums

With risker assets reversing much of losses seen in early August, it’s obvious the yen is once again being used as a funding vehicle to facilitate carry trades into USD-denominated assets. But it’s not the only currency that’s experienced a rebound against the yen. Capital is also rushing towards other geographic locations, especially those currently outperforming.

As seen in Citi’s economic surprise index below, data in the United Kingdom has been topping expectations in aggregate since the early parts of May, contributing to the outperformance of GBP against most developed market currencies., including JPY.

Source: Refinitiv

GBP/JPY breaks above 200DMA

With macroeconomic and market conditions favourable for carry trades, it comes as no surprise to see GBP/JPY has managed to break back above the 200-day moving average, an important level the price often respects once broken.

With RSI (14) and MACD continuing to provide bullish signals on price momentum, and with GBP/JPY remaining closely correlated with S&P 500 futures over the past month, underlining the importance that risk appetite is playing in helping carry trades to work, the path of least resistance appears higher in the near-term.

Following the break of the 200DMA, traders can now use it to build bullish trade setups around, allowing for a stop to be placed underneath the level for protection. 193.54 would be the obvious initial target, marking the March 2024 highs which is also where the price stalled on Monday. Beyond, minor resistance is located at 196.00 with the important 50-day moving average the next topside level after that.

The bullish bias would be negated if the price were to reverse back below the 200DMA, pointing to either sideways range trade or downside risks. Such a scenario would likely require renewed concerns about the health of the US economy, leading to Fed rate cut bets to swell. 

AUD/JPY next?

The bullish break in GBP/JPY may forewarn of a similar move in AUD/JPY, another target currency that has been outperforming relative to expectations recently. Citi’s economic surprise index for Australia pushed back into positive territory last month, indicating that more economic data is now beating expectation than missing. That’s been a rarity throughout much of 2024.

Source: Refinitiv

AUD/JPY now finds itself just below the 200DMA, like GBP/JPY up until Monday. With momentum indicators generating bullish signals and a close correlation with riskier asset classes, the path of least resistance appears higher. The 200DMA is an important level for AUD/JPY, often tested but rarely crossed in recent years. Sitting in what looks to be a bearish flag pattern, you get the sense that if it can’t break the 200DMA soon, downside risks may materialise quickly, bringing a retest of 96.92 or lower into play.

Like GBP/JPY, a break of the 200DMA can generate a variety of fresh bullish setups, allowing for stops to be placed below the level for protection. On the topside, the 50-day moving average is the first level of note, especially as it coincides with channel resistance. If it were to go, 102.64, 104 and 104.95 are levels to note.

I cannot stress the importance that risk appetite needs to hold up in order for yen carry trades to work, placing extreme importance on upcoming US labour market data given it is the largest and arguably most important economy globally. This is especially so at a time when growth in China and continental Europe remains sluggish. 

-- Written by David Scutt

Follow David on Twitter @scutty