Market update: global sell-off takes a breather

Markets show relief after yesterday’s global sell-off

The effects of yesterday’s global sell-off appear to be easing on Tuesday. Risk gauges like the VIX, the yen, and the Swiss franc have seen the selling hold up for the time being. The sharp global sell-off has been influenced by a number of factors, but one stands at the heart of it: the carry trade unwind.

Impact of central bank policies

With the Fed posturing for a rate cut and the Bank of Japan normalising its monetary policy through rate hikes, a drop in USD/JPY always seemed likely. However, the speed of its unravelling has shocked markets. For years, investors took advantage of ultra-low interest rates in Japan to borrow yen and then invest that cheap money in higher-yielding investments like stocks or even treasuries.

Market expectations and reactions

Markets currently price in a 75% chance the Fed will kickstart the cutting cycle with a 50 basis point (bps) reduction in September, instead of the usual 25 bps, after the US unemployment rate rose to 4.3% in July. Such concern sent the dollar lower, and the BoJ surprise hike last month helped to strengthen the yen at the same time. Therefore, the interest rate differential between the two nations will be reduced from both sides, souring long-standing carry trades.

Investor strategies amid volatility

Investors and hedge funds that borrowed in yen were forced to liquidate other investments in a short space of time to finance the settlement of riskier yen-denominated loans/debts. A fast-appreciating yen means it will require more units of foreign currency to purchase yen and settle those yen-denominated loans.

USD/JPY sell-off pauses, threat remains

This week, Fed members attempted to instil calmness in the market, accepting that the job market has eased but cautioning against reading too much into one labour report. The Fed has admitted that the risks of maintaining restrictive monetary policy are more finely balanced. Holding rates at elevated levels hinders economic activity, hiring, and employment, and so at some stage, the fight against inflation can jeopardise the Fed’s employment mandate.

The Fed is expected to announce its first rate cut since the hiking cycle began in 2022, but the discussion now revolves around the number: 25 bps or 50 bps? Markets assign a 75% chance of a 50 bps cut, which has amplified the downside move in USD/JPY.

While the RSI remains well within oversold territory, this is a market that has the potential to drop for some time. The unravelling of carry trades is likely to continue as long as the Fed and BoJ remain on their respective policy paths. 140.25 is the next immediate level of support for USD/JPY, but it wouldn’t be surprising to see a shorter-term correction given the extent of the multi-week sell-off.

USD/JPY daily chart

AUD/JPY embodies the risk-off trade within the FX world

AUD/JPY can be viewed as a gauge for risk sentiment. On the one hand, you have the Australian dollar, which has exhibited a longer-term correlation with the S&P 500 – which itself is known as a risk asset. Therefore, the Aussie typically rises and falls with swings in positive and negative risk sentiment. On the other hand, the yen is a safe-haven currency – benefiting from uncertainty and panic.

Recent movements in AUD/JPY

The AUD/JPY pair has revealed a sharp decline since reaching its peak in July, coming crashing down at a rapid pace. Both the 50- and 20-day SMAs have been passed on the way down, offering little resistance.

Short-term correction possibilities

Yesterday’s intra-day spike lower and subsequent pullback suggest we may be in a period of short-term correction, with the pair managing to rise at the time of writing. The AUD/JPY lift has been helped by the RBA Governor Michele Bullock stating that a rate cut is not on the agenda in the near term, helping the Aussie gain some traction. Her comments come after positive inflation data, which has put prior talk of rate hikes on the backburner.

95.75 is the next level of resistance, with support at yesterday’s spike low of 90.15.

AUD/JPY daily chart

• _{This information has been prepared by DailyFX, the partner site of IG offering leading forex news and analysis. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.}