How Will the Markets React?
There are no major economic releases on the calendar Monday so we are diverging from the usual style of the Cross Markets Data report and will instead take a look at what the other markets are signaling for carry trades in the week ahead. With the exception of GBP/JPY and USD/JPY, the other Japanese yen crosses have performed extremely well over the past few trading days. In fact just today, the Yen weakened to a monthly low against currencies like the Euro, Swiss Franc, Australian, New Zealand and Canadian dollars. The primary reason why these currency pairs have performed so well is because the Dow Jones Industrial has rallied 400 points this week, bringing some risk appetite back into the markets. However given the big moves that we have seen thus far, it is unclear whether this strength will continue, so let?s take a look at what the other markets may be suggesting:
Bonds - 10 Year US Treasury Note Futures
Treasury bond prices are up on the day which is actually quite interesting since the stock market and carry trades are both higher. Usually, when the stock market rallies bond prices fall and yields rise because it reflects better business conditions or less of a need to lower interest rates. However a closer look at the following chart indicates that the rally is simply a mild recovery from recent weakness. In fact, 10 year Treasury notes have rebounded to an important resistance level which means that a downtrend could resume. If bond prices are expected to move lower, that suggests that traders are moving out of US bonds and into riskier assets in which case, carry trades could continue to rise.
Volatility - VIX Index
Carry trades usually perform well in periods of lower volatility. The following chart of the CBOE Volatility Index indicates that not only has volatility fallen over the past 24 hours, but it appears poised to move back to June levels. The outlook for lower volatility in the week to come also suggests that the rebound in carry trades could continue.
FX - AUD/JPY
Nearly all of the Japanese Yen crosses are considered carry trades. So for this report in particular, we will simply analyze AUD/JPY, one of the market?s most popular carry trades. If you take a step back, you can see that AUD/JPY is still in a corrective mode, meaning that the recent strength can still be categorized as a rebound after the sharp weakness seen in early August. This rebound has now hit a critical resistance level created by the 100-day SMA (blue line). FX itself appears to be the one market that diverges from the others in showing resistance for carry trades rather than more room for gains.
Equities - Dow Jones Industrial Average
Finally lets take a look at the Dow, which single handedly has been the biggest driver of recent carry trade strength and weakness. The Dow has cleared two critical resistance levels over the past week (13,500 and 13,700) and even though we have stalled and consolidated over the past 3 trading days, there is no major resistance until 14,021 which is the record high in the equity market index. Although it is difficult to believe that equities can rally back to its highs in an environment where US growth is slowing, from a technical perspective, there is nothing stopping the move and from a fundamental perspective, the recent Fed funds and discount rate cut goes a long way in lowering borrowing costs. The potential for further gains in the Dow suggests the potential of further gains for carry trades.
Written by Kathy Lien, Chief Currency Strategist of DailyFX.com