AUD/JPY outlook: Bullish signals clash with rising bond risks

• AUD/JPY correlations with equities and volatility near historical highs
• Yield differential between Australia and Japan driving upside momentum
• RSI and MACD still bullish, but upside strength has stalled

Summary

AUD/JPY has reclaimed its role as a risk proxy, surging on low volatility and widening yield spreads to levels last seen in mid-2024. Correlations with equities and volatility indices confirm the pair’s sensitivity to risk appetite, but rising global bond yields cast a shadow over the bullish narrative. Technicals lean bullish, yet the macro backdrop warns that the party could end abruptly.

Risk Proxy Returns

AUD/JPY has reverted to its traditional role in the FX universe as a barometer of broader risk appetite, using a combination of low volatility in stocks and bonds, gains in riskier asset classes, and widening interest rate differentials to climb to levels not seen since July last year.

We can see this in the rolling 10-day correlation coefficients between AUD/JPY and various market indicators in the chart below. From top to bottom, the scores are 0.83 with Nikkei 225 futures, 0.89 with Nasdaq 100 futures, -0.86 and -0.79 respectively with VIX futures and the MOVE index, along with 0.91 with two-year yield differentials between Australia and Japan.

Source: TradingView

The latter is shown visually in the left-hand pane overlaid against AUD/JPY, demonstrating not only the correlation between the two but also that the recent hawkish recalibration in the Australian interest rate curve has far exceeded that in Japan, despite traders now firmly favouring a rate hike from the BOJ in late December.

As a reminder, correlation coefficients measure how closely two variables move together. A reading of +1 means they rise and fall in perfect sync, while -1 means they move in opposite directions every time. A score of 0 signals no relationship at all.

While correlation does not imply causation, when it comes to these particular markets, the tight relationships confirm AUD/JPY is essentially acting as a risk proxy. Should that remain the case, a continuation of the low-volatility melt-up in riskier asset classes points to the likelihood of an extension of the bullish move, while a deterioration in risk appetite risks derailing the strong uptrend.

AUD/JPY Delivers Unconvincing Breakout

Looking at AUD/JPY on the daily chart, while the pair hit fresh YTD highs earlier this week, the breakout has been anything but spectacular, with an initial probe higher failing to extend and delivering a doji candle pointing to broader indecision. That’s not overly surprising considering we’re seeing longer-dated bond yields around the developed world pushing higher, creating an uncomfortable macro backdrop for riskier assets given elevated valuations following recent sharp gains. You get the sense that everything is fine until it isn’t, but trying to predict the exact timing of when and if the bond vigilantes decide to crash the risk party is very difficult. The threat is already here.

Source: TradingView

Considering where AUD/JPY trades and the uncertain macro backdrop, the November 2024 high of 102.40 can be used to build trade setups around. Should the breakout stick with the price holding above the level, longs could be established above it with a stop beneath for protection, targeting either 104.00 or 104.95. Alternatively, if we see a false break with a reversal back beneath 102.40, the setup could be flipped with shorts established below the level with a stop above. 101.50, the November uptrend, 100.38 or the 50DMA screen as potential targets, depending on desired risk-reward.

While RSI (14) and MACD continue to offer bullish signals, favouring a similar bias when it comes to directional setups, upside strength has remained relatively stable for the better part of a month, likely explaining the grinding price action we’ve seen in the pair. Long setups are still favoured over shorts, but the message is not a definitively bullish one for traders.