AUD/USD, USD/JPY: Biased higher should soft landing narrative hold

• AUD/USD and USD/JPY remain plays on the US interest rate outlook
• Markets favour two supersized Fed rate cuts in 2024
• Any further addition to Fed rate cut pricing implies growing risk of a hard US economic landing
• US retail sales, Canada inflation key releases on Tuesday

Overview

Both AUD/USD and USD/JPY remain plays on the US interest rate outlook. The only real difference is the former is being influenced more by expected byproducts from Fed rate cuts, rather than rates directly like the yen.

Rate plays either directly or indirectly

This chart looks at the rolling 20-day correlation between both FX pairs with a variety of different variables which have been labelled. AUD/USD is the left-hand pane, USD/JPY the right.

What’s obvious is AUD/USD is behaving like a cyclical risk asset, showing far stronger relationships with crude oil and US stock futures than US interest rates directly like USD/JPY.

The readthrough is that if traders continue to run with the soft landing narrative, we may see further upside for AUD/USD but limited downside for USD/JPY. But if Fed rate cut pricing were to increase significantly further, it would imply a growing risk of a hard economic landing, likely dragging AUD/USD and USD/JPY lower.

Incoming economic data will therefore be important ahead of the Fed.

Tuesday event risk

While the Fed decision on Wednesday afternoon in Washington DC stands head and shoulders everything else this week, there are some data releases coming up later Tuesday that could skew market pricing on the magnitude of rate cuts the Fed delivers over the next 12 months. Times shown below are US EDT.

US retail sales will be important given household spending is the largest part of the US economy. If it weakens, it’s a safe bet the economy will too. Industrial production figures will scrutinised closely given it’s another read on the cyclical side of the economy.

For USD/JPY, one wildcard will be the 20-year Treasury bond auction later in the session. Given the yen is being heavily influenced by US interest rate movements along the entire US curve, any signs of softening demand from the recent decline in yields could deliver an uplift in USD/JPY.

Further north, Canada’s inflation report will be watched closely by those in Australia and the US, not only because of the proximity of the latter but also economic and demographic similarities with the former. The Bank of Canada was among the first major central banks to begin cutting interest rates, providing a sighter as to what may occur elsewhere in the developed world in the near future.

AUD/USD remains a cyclical risk asset

From a technical perspective, AUD/USD looks increasingly bullish on the charts, breaking minor downtrend resistance on Monday after an initial failure last week. RSI (14) has broken its downtrend, pointing to shifting market momentum. MACD looks like it may soon confirm the bullish signal, adding to the brightening picture. Under these types of market conditions, directional risks appear skewed to the upside.

Those keen to get long could buy around current levels or wait for a potential reversal towards .6733, the high struck last Friday. There is a risk we may see some modest near-term weakness if markets trim what come across as overly dovish Fed rate cut pricing.

A stop below .6733 would offer protection. Potential topside targets include .6766, the high of September 6, along with the August 29 peak of .6825. If that were to be breached, .6871 should be on the radar.

USD/JPY a proxy for US rates outlook

USD/JPY staged a decent reversal after slicing through the December 28 low of 140.273 on Monday, printing a hammer candle on the daily. With RSI (14) nearing oversold territory and breaking the downtrend it’s been in since the start of September, USD/JPY comes across as a prime squeeze candidate should the Fed disappoint dovish market expectations, or if incoming US data prints strongly.

Those playing for such an outcome could see if the price holds above 140.273 today, allowing for longs to be established with a stop around 139.60, below the low set on Monday. Make sure you keep positioning front of mind given how volatile the pair has been recently.

Potential topside targets include 141.73 and 143.63, the latter acting as support and resistance over recent weeks.

-- Written by David Scutt

Follow David on Twitter @scutty