The EUR/JPY pair is an important currency pair, often watched closely as a barometer of risk-on activity. The more that the pair is bid up, the more that the market is thought to be signaling risk-on activity. The reverse is true: when the euro weakens against the yen, a risk-off signal is offered, which typically translates into weakness among risk assets such as U.S. equities.
The chart below demonstrates this; the daily candlesticks present EUR/JPY price action, and the purple line illustrates how S&P 500 futures have traded with positive correlation to the same currency pair. The bottom indicator provides us with a view of the rolling 50-day correlation.
Clearly, the correlation fluctuates both in strength and direction. It becomes even noisier when you look at, for example, the 20-day rolling correlation. Nevertheless, even the most useful correlations we can find through inter-market analysis tend to fluctuate in strength and direction. The point is, the price action tells the main story: sometimes equities lead EUR/JPY, and at other times the reverse is true, but ultimately they tend to follow each other.
EUR/JPY began to fall most noticeably from late April of this year. The pair peaked early on in the year, marking a high of 127.502 on March 1, 2019. Since then, EUR/JPY has traded with an overwhelmingly bearish direction, such that it has recently dropped to the lows of the year (currently: 118.357, at the time of writing).
This price action, like most moves in the currency world, has been supported and led by changing rate expectations. Using one-year government bond rates, we can map the yield differential offered by German bonds against Japanese bonds to gauge the short-term carry offered by EUR/JPY.
As always, the higher the spread the better, while a lower spread usually leads to downside. Further, a positive carry is usually needed for true, long-term currency appreciation, while negative carry typically strengthens the downside case.
As you can see from the spread indicator above in the chart above, the pair has ticked down just as the interest rate spread has worsened. This is interesting given that both German short-term rates and Japanese short-term rates are negative. However, while one-year German bund rates are about -0.76% at the time of writing, the Japanese counterparts trade at yields of -0.22%. The spread is therefore net negative; in this case in favor of the yen.
However, an important caveat: the figure below (provided by forexop.com) shows certain broker-offered carry spreads for various currency pairs as of recent. Note how EUR/JPY is across to the far right, and in fact negative.
The spread may be positive for some brokers, but negative for others. Various factors can affect these spreads, including administrative fees, and that is not to mention taxes and so forth. The point here though is that the spread is so tight that being short EUR/JPY is not at all a strong carry trade.
Further, I believe that future moves in rates will affect EUR/JPY disproportionately: if the spread worsens below -1.00% (currently circa -0.50% going by bond yields), it will suddenly become more economically appetizing from a carry-trade perspective to short the pair. The inverse is true: if the spread improves, EUR/JPY could spike higher.
However, with the rate already negative, and with the Bank of Japan's bank rate already being in negative territory, an argument could be made that the euro has more room to weaken than the yen (the latter also being traditionally viewed as a safe-haven currency).
In addition to the yen-favorable interest rate spread, equities have declined recently, strengthening the case for a stronger yen and perhaps precipitating this risk-off move we are seeing in both EUR/JPY and global equities. If you look closely on the chart above though (the chart presented before the carry-trade graph), you will see that the price of the EUR/JPY pair has steadied at a somewhat similar level to the flash crash low of 118.824 registered on January 3, 2019.
Admittedly, the price has sunk beneath this flash-crash low, but with the interest rate spread also improving modestly, EUR/JPY may be able to find some modest strength to consolidate in this region. A failure to do so would be bearish for all yen crosses, and for risk assets such as equities more broadly.
Using volume profile analysis - which we can use to find well-traded and thinly-traded areas - we can estimate (using a longer-term daily chart) where price may find support and resistance, in light of the prevailing bearish trend.
As illustrated in the chart, the potential levels to the upside are far more easily identifiable. Most of the tick volume has traded above. Unfortunately for this pair, it has now left its prior trading range. Therefore, prior levels are now more likely to be met with great struggle, and exploited mainly for sell-side liquidity. Unless the spread improves significantly, retracements to the upside should be met with great skepticism.
Nevertheless, in order of probability (from highest to lowest), the medium term could see EUR/JPY trade at 119.450 (reasonable probability), 120.830 (lower probability), 121.500 (much lower probability), and 122.210 (unlikely, in this author's view). A break of 122.210 could see a reversal of the bearish trend.
To the downside, 118.075, which has already been taken, is likely to be retested and broken. Afterwards, 117.370 would appear to be a clear target. Underneath 117.370, there is much more room for the pair to fall. Previously, a low of 114.851 was registered on April 17, 2017. Zooming out of the above volume profile chart, I draw a horizontal black line illustrating this low.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.