It's nice that the U.S. equity market is making new post-recession highs, but one of the biggest things happening on the margin is the decline of the Japanese yen.
The chart above offers some long-term perspective on the yen/dollar exchange rate, by comparing the spot forex rate against my calculation of the yen's Purchasing Power Parity. The yen hit an all-time high of 76 vs. the dollar just over a year ago, a value that I calculate was about 50% above its PPP. The yen, in other words, was extremely strong. A very strong currency is symptomatic of tight monetary policy, an environment that has prevailed for almost three decades in Japan. It's not surprising, therefore, that Japanese inflation has been zero or negative for the past two decades.
In the past few months there have been some big changes in Japan, with powerful political pressures being brought to bear on the Bank of Japan to adopt an aggressively accommodative monetary policy. That this may turn out to be successful in turning chronic deflation into some form of positive inflation is reflected in the yen's 14% decline -- from 78 to 91 -- against the dollar in the past four months, most of which has occurred since mid-November. As the chart also suggests, there is plenty of room for the yen to weaken further against the dollar.
This next chart shows how the value of the yen has been an important factor driving the Japanese equity market. Beginning in 2007, the yen surged from 123 to its all-time high against the dollar in late 2011 -- a staggering increase of 62%. This coincided quite closely to the 55% decline in the value of the Japanese stock market over the same period. Tight money not only gave Japan a case of deflation, it severely depressed the value of the Japanese equity market. Now, with the yen down 13% since mid-November, the Nikkei 225 is up 26% in dollar terms -- a remarkable reversal of fortune.
It's probably not a coincidence that spot commodity prices, as measured here by the CRB Raw Industrials index, are up over 9% since November. The outlook for Japan's moribund economy is improving as the yen weakens, which in turn is likely whetting the Asian region's appetite for commodities. The weaker yen seems to be improving the outlook for the U.S. economy as well, with the S&P 500 up 11% since mid-November.
As the chart above shows, since peaking early last year, commodity prices have lagged significantly the rise in gold prices. It could be that commodities now have some catching up to do (they would need to rise by as much as 40% to reestablish their former relationship with gold), and the latest rise is just the first chapter in that story.
I don't pretend to fully understand all of this, but the relationship between the yen, equities, and commodity prices is too powerful to ignore.