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Top 2023 Trade: Short EUR/JPY on Carry Trade Unwind as EU Fundamentals Worsen

Top 2023 Trade: Short EUR/JPY on Carry Trade Unwind as EU Fundamentals Worsen

Richard Snow, Analyst
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EU Fundamentals

2022 was synonymous with interest rate hikes as central banks fought runaway inflation which has shown signs of moderating in the latter stages of Q4 but remains problematically high. But markets have entered a period of transition consistent with declining sovereign yields, resilient equity and labor markets, as well as a sense of optimism around lower inflation – encouraged by central bank forecasts.

The European Central Bank (ECB) forecasts modest real GDP growth of 0.9% for 2023 or a 0.9% contraction under its worst case scenario which assumes a prolonged war in Ukraine and cold winter temperatures drawing on finite gas supplies with little scope for alternatives. Inflation is expected to ease to 5.5% which is still stubbornly high. At the time of writing, temperatures have plummeted in Europe despite a rather mild autumn which is set to test levels of gas consumption and likely raise gas prices after already seeing a lift at the end of 2022. Therefore, declining real income is likely to reduce local consumption, and a generally weak global economy is likely to negatively impact exports with inflation lingering.

Japanese Fundamentals

Japanese inflation reached 3.6% in October, the seventh straight month where general prices rose above the Bank of Japan’s (BoJ) 2% target but the bank remains resolute that inflation will drop back to the target in 2023 and is in no rush to alter its ultra-dovish policy stance. Because of Japan’s ultra low rates, 2022 was the year of the carry trade, setting up 2023 to be the year of the carry trade unwind as global yields ease. Already the German 10-year Bund has witnessed a decline of more than 25% from the peak, reducing the interest rate differential built up over 2022. It is with this in mind that EUR/JPY appears susceptible to declines in Q1 of 2023.

10-Year German and Japanese Differential

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Chart prepared by Richard Snow, Tradingview

Short EUR/JPY: Tehcnical Considerations

The monthly EUR/JPY chart highlights the pair’s impressive ascent which appears to have bounced of a rather stern level of resistance at 148.40 – a level that has capped major bull trends in the past. Such elevated levels place this pair in a favorable position if indeed we are to see lower prices throughout the majority of Q1.

EUR/JPY Monthly Chart

image2.png

Chart prepared by Richard Snow, Tradingview

In the event we have already witnessed the peak of the bull run at 148.40, the Fibonacci retracement levels provide a handy guide for areas to the downside that are of interest. The daily chart reveals price action trading below the June swing high, with the 23.6% retracement as the first level of support (140.40) and first real test of a potential bearish reversal. Thereafter, the 138.32 level comes into play as it has done so in the past and once again, this is a level where a bearish continuation can be assessed before the 38.2% retracement, at 135.42, comes into focus. 135.42 served as support in April, August and September this year and ultimately acted as a springboard for the move higher. A move above 149.00 would invalidate the bearish bias, at least for the time being.

EUR/JPY Daily Chart

image3.png

Chart prepared by Richard Snow, Tradingview

Conclusion:

Worsening fundamentals in Europe weigh on the euro while the yen is in prime position to benefit from a carry trade unwind. Pairing the potentially weak currency with the potentially strong currency near the peak of a slowing bull trend provides an opportunity for a short EUR/JPY trade for Q1 2023.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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