AUD/JPY heading into the eye of the perfect storm

  • AUD/JPY is struggling to break out of the bear's layer.
  • AUD finding support on unfounded optimism in the grander scheme of things. 
  • The US dollar to retain its title as top currency in the next financial markets shock.

AUD/JPY, fulled by a positive Aussie and Chinese data, is trading at 69.01 and 1.69% higher on the day having travelled from a low of 67.03 to a high of 69.15. There are mixed messages in the price action this week.

We have a deteriorating macro backdrop for the global economy yet, somehow, the most vulnerable asset classes are showing their resilience, defiant of the elephant in the room  – COVID-19. The following is an illustration for the case for shorting AUD/JPY. 

The case for shorting AUD/JPY

COVID-19 is going to be with us for a long time to come – if not in physical form, (should a vaccine and cure eradicate it from planet earth), it will surely have left its mark on society and the global economy in a number of facets. 

While some countries have fared remarkably well in dealing with COVID-19 and its economic shock, such as Australia and a number of countries in the Asia-Pacific region, (AUD positive), the majority of the world, especially developed nations, have struggled mightily with the virus and the economic fallout.

Then, the developing nations, such as those in Central America, are seeing the divide between the haves and have-nots widen further and many of whom were on the brink of poverty have now fallen into extreme poverty, literally overnight.

While we may have seen the initial shock to financial markets wipe out a good chunk of the prior's crashes recovery, we are by no means out of the woods yet. On a number of counts and scenarios, things could get a lot worse for markets (and AUD) before they can get better.

Staying with Australia, while we are seeing some upside in the currency, fuelled by optimism over how well Australia has contained the virus along with some positive data surprises in the region, (Aussie and Chinese trade balances (above)), what markets are not taking into full consideration is how badly affected domestic consumption will be by the shutdown measures.

"Google mobility trends data suggest a substantial decline in activity since the lockdown measures. Substantial fiscal and monetary support is likely to buffer the slowdown, but not prevent Australia’s first recession since 1991," analysts at Standard Chartered have argued:

Government spending aimed at enabling businesses to retain workers should prevent a rapid rise in unemployment; nevertheless, we expect the unemployment rate to peak at c.11%.

Key projections from Standard Chartered

  • We lower our 2020 growth forecast to -5.1% y/y, the worst annual contraction in Australia’s history.
  • Q2 is likely to see the biggest contraction (over -12% y/y); we expect a mild recovery from Q3 onwards.
  • Risks are skewed to the downside; we forecast a contraction of up to 11% y/y in a pessimistic scenario.
  • We lower our 2020 inflation forecast to 0.7% y/y (1.8% prior) on slower economic activity, lower oil prices.

When you slap those gruesome projections against that of prospects for the global economy over the year from Deutsche Bank's, its a frightening picture for global markets, trading in the face of a possible global depression:

In a new baseline projection, we now see global GDP falling 10% in Q2 and remaining well below pre-virus levels through most of next year. This implies a nearly 6% decline in GDP for the year 2020, more than double consensus projections of this year's drop as of mid-April.

USD to benefit from prolonged trade wars

Trying to find bright spots in all of this is a tall order, yet markets have been doing it. For a market so reliant on positive outcomes from global trade data, it is doing a pretty good job at it when disguising such dependence in the face of trade wars between the US and China rearing its ugly head again.

Such sentiment had started to weigh on AUD, before it managed to somehow dig its way out of the dangers falling below critical support in 0.6380s. More on that here: AUD/USD dropped below 0.64 handle on trade war escalatory headlines.

Meanwhile, in a best-case scenario, whereby scientists do manage to either find an effective antiviral drug or quicker development of a vaccine, or both, which could lead to a much faster return toward more normal levels of activity and substantially lower levels of global unemployment, we will still have to contend with China and the US at the brink of war as well as the distribution to the global supply chains. 

If the 2018-202 trade war was any kind of a road map for what is to follow, then we should be confident in knowing that the US dollar will be the major beneficiary of a prolonged trade spat between China and the US. The markets have demonstrated to us that in any financial shocks in the markets, between now and then, the dollar will again be the major beneficiary.

Moreover, despite the waves of supply a centralised effort by the central banks to supply dollars in the market, the greenback has still managed to stay on top regardless. This should, therefore, equate to a weaker yuan and AUD, which has traded as a proxy with a negative correlation to the trade wars over the years. 

"There are sharp differences within G10 FX in containing Covid-19, with the better performers presumably able to revive their economies faster," analysts at Westpac argue. "But we suspect that it is too soon to expect outperformers such as AUD and NZD to rally sustainably against the US dollar, despite the US's poor performance in limiting the spread of the virus."

The perfect storm for short AUD/JPY 

The perfect storm could be developing for short AUD/JPY.  Long yen for its shave haven appeal, especially IF the USD does struggle to pull in as much as a safe haven bid (US economy on the brink/worts hit by COVID-19) and short AUD for its close correlating to trade war uncertainties and its vulnerability to a Chinese and a global economic depression. 

AUD/JPY technical outlook

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