The Carry Trade

Simply put, the carry trade is the act of borrowing in a currency with low interest rates and using those funds to buy assets with higher rates or anticipated returns (like stocks). The Japanese yen became an “easy” carry trade for big investors because the Japanese yen (FXY) had near zero interest rates. Once the Fed started hiking rates, traders could earn increasing returns by borrowing in yen and buying U.S. bonds. After equity markets bottomed in October, 2023, traders could earn increasing return borrowing yen to buy stocks (at least one analyst thinks the carry trade has been in effect since the rebound from the Great Financial Crisis!). Crypto currencies are even acting like they have been caught up in this massive delveraging. At the time of writing Bitcoin (BTC/USD) is down around 24% in just 8 days and looks like it could soon reverse all its gains since the SEC approved Bitcoin spot ETFs.

The strength in the yen and the presumed unwind of the carry trade has been breathtaking over the last two weeks. The Australian dollar versus the Japanese yen (AUD/JPY) has fallen around 17% in the three weeks since its last peak. AUD/JPY now sits at levels last seen in early June, 2023. AUD/JPY has long been my favorite currency market indicator of sentiment in the stock market. However, the current decline happened so rapidly, that I had no time to adjust my mind to appreciating that AUD/JPY suddenly mattered again in a significant way. After all, the Bank of Japan “only” hiked its target rate from 0% to 0.25%. The hawkish tone of the BoJ on normalizing policy must have traders scrambling to get completely out of the way of future rate hikes.

So what now?

Financial markets are essentially in panic mode. It is near impossible for the stampeding herds to see the other side of this major market disruption. As a contrarian of extremes in financial markets, I am compelled to lean the other way even though market breadth in the stock market still needs to fall significantly to hit oversold levels. Thus, I cannot buy as aggressively as I normally would…”nibbling” is my modus operandi for now (I am also re-accumulating cryptocurrency positions like BTC/USD).

In currency markets, I slipped on my well-crafted trading strategy on the Japanese yen. I gave up on the short GBP/JPY too early, and got overly confident in what looked like the obligatory rebound for USD/JPY side. So, in recent days, I have raced to keep up with new short GBP/JPY positions and have been simply astounded by how fast these positions hit profit targets. This clearing in turn forces me to reload at lower prices as the Japanese yen keeps racing away. Last week, I even dabbled in shares and call options in Invesco CurrencyShares® Japanese Yen Trust ETF (FXY). At SOME point, this non-stop slide in yen currency pairs will end and give way to a (potentially) abrupt and vicious countertrend relief rally. That time will offer a brief opportunity to bail on short yen positions and then step aside to catch a few breaths!

Be careful out there!

Full disclosure: long AUD/JPY, long USD/JPY, short GBP/JPY, long BTC/USD

The post The Carry Trade Sweeps the Sahm Rule Aside appeared first on Inflation Watch.

The 15-minute chart of AUD/USD shows how traders rushed to buy in the wake of a surprise rate hike. The enthusiasm peaked within 3 hours. (Source: TradingView)

The RBA acknowledged that “inflation in Australia has passed its peak.” However, inflation at 7% is too high and “…while the recent data showed a welcome decline in inflation, the central forecast remains that it takes a couple of years before inflation returns to the top of the target range.” This inflation horizon means the RBA could intermittently hike rates for quite some time as it scours the landscape for smoldering embers of inflation.

The current problem is in services price inflation. The U.S. also faces this challenge. Indeed, he RBA referenced global commonality in explaining the sources of stubborn highly inflation (emphasis mine):

“Goods price inflation is clearly slowing due to a better balance of supply and demand following the resolution of the pandemic disruptions. But services price inflation is still very high and broadly based and the experience overseas points to upside risks. Unit labour costs are also rising briskly, with productivity growth remaining subdued…Wages growth has picked up in response to the tight labour market and high inflation.”

The RBA further explained that the rate hike should firmly anchor medium-term inflation expectations. Tightening monetary policy is acting like an insurance policy against higher inflation expectations contributing “to larger increases in both prices and wages, especially given the limited spare capacity in the economy and the historically low rate of unemployment.” Unemployment in Australia remains at a 50-year low. Thus, the RBA has plenty of room to continue tightening as needed…at least for now. The RBA acknowledged the challenge ahead in avoiding a recession while it tightens monetary policy:  “the path to achieving a soft landing remains a narrow one.”

The RBA concluded the May statement on monetary policy just as it ended the previous statement: “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will depend upon how the economy and inflation evolve.” In other words, the market will need to stay on its toes.

The Trade

The intraday surge in AUD/USD was not enough to punch the currency pair through important resistance on the daily level. AUD/USD remains trapped underneath resistance from all three major trendlines: the 20-day moving average (DMA) (dashed line), 50DMA (red line), and the 200DMA (blue line). Thus, I am neutral on AUD/USD until at least after I see how the market responds to the Federal Reserve’s turn to announce monetary policy.

AUD/USD has been stuck in a range for two months. Resistance from the 20DMA, 50DMA, and 200DMA are now capping upside. (Source: TradingView)

The Australian dollar versus the Japanese yen (AUD/JPY) is much more interesting, especially with the Australian dollar holding a significant yield advantage. The Japanese yen is suffering a fresh bout of weakness because the new governor of the Bank of Japan confirmed that he has little interest in tightening policy from ultra low rates. The double dose of yen weakness and Australian dollar strength hurled AUD/JPY right into overhead resistance at the 200DMA. A rush to the “safety” of the yen in the wake of fresh selling in the U.S.’s regional banks help send AUD/JPY in reverse. Still, while the 200DMA held as resistance, AUD/JPY is now making higher highs and higher lows with the 20DMA in an uptrend. The current 50DMA breakout could hold given this fresh momentum. (Recall that a bullish AUD/JPY has bullish implications for the stock market).

Overall, with the RBA on a path that could include higher rates for some time, I like buying the Australian dollar on dips on the assumption it has likely bottomed against the U.S. dollar and the Japanese yen. I am currently (re)accumulating AUD/JPY on this pullback in anticipation of an eventual retest of 200DMA resistance.

AUD/JPY has traded in a well-defined range all year. The latest uptrend is the latest opportunity to build enough momentum to break out. (Source: TradingView)

Be careful out there!

Full disclosure: long AUD/JPY, long FXA

The post Reserve Bank of Australia Revives the Ghost of Inflation Past appeared first on Inflation Watch.

The Australian economy remains quite strong. The RBA expects growth this year to hit 3.25% and 1.75% in 2023 and 2024. The slowing growth will not cause a significant boost in unemployment which is currently near 50-year lows. This strength gives the RBA room to continue hiking rates as planned. So it is a wonder that the Australian dollar is not faring better against its major rivals in the Japanese yen (AUD/JPY) and the U.S. dollar (AUD/USD). In particular, the Australian dollar looks like it is topping against the Japanese yen with the often dreaded head and shoulders pattern.

AUD/JPY is just one breakdown below the “neckline” away from confirming the topping pattern. (I almost arbitrarily drew the neckline at the point of the last meaningful, tested support level). In the meantime, I am actually betting on a near-term rebound in AUD/JPY before the head and shoulders pattern resolves itself to the downside or upside. The RBA’s monetary policy is racing ahead of the Bank of Japan, so I interpret the yen’s recent general strength as a counter-trend rally or even some kind of short-covering rally. Time should tell soon.

Full disclosure: long AUD/USD, long AUD/JPY

The post The Reserve Bank of Australia Looks Ahead to Peak Inflation appeared first on Inflation Watch.