Starting in November 2012, Japan's longstanding efforts to devalue its currency finally began experiencing sustained success. Since the massive devaluation process started, both the Nikkei (EWJ) (NKY) AND the S&P 500 (SPY) have experienced large gains. The simultaneous and complementary moves over these past many months are similar to what one might expect from a carry trade converting cheap yen (FXY) into paper in the stock market.
The Nikkei has soared during the yen's sharp devaluation versus the U.S. dollar
In the chart above, the Nikkei is represented by the black line (or gray area), the blue line is USD/JPY (the higher the ratio, the weaker the yen relative to the U.S. dollar), and the red line is the S&P 500. The eyes can of course follow along and see the apparently strong correlations. That is, until about June 18th. After that point, the U.S. dollar continued to recover against the Japanese yen after a month-long correction, the Nikkei stalled, and the S&P 500 experienced a sharp sell-off. The backdrop was a surge in U.S. Treasury yields (TLT). When the S&P 500 recovered some lift in the last week of June, the Nikkei joined, and the U.S. dollar continued to increase against the yen.
At the time of typing, USD/JPY was challenging the psychological 100 level again despite what I think are a lot of assumptions that the yen's weakness had finally come to an end. For example, I have seen charts showing that Japanese investors have been net sellers of foreign bonds, not buyers as many expected. Without the currency outflow to purchases these bonds, the assumed implication is that the yen would not weaken as previously expected, it might strengthen even. I believe that the Bank of Japan (BoJ) remains fully committed to weakening its currency and thus will eventually succeed in reaching whatever target it has to achieve its 2% inflation target. This process will not happen in a straight line and data points like bond flows will likely turn into small distractions and/or bumps in the road along the way. Having said all that, the 100 level should prove more difficult to break than the last time around, so I am currently net long the Japanese yen as a short-term play on this resistance.
USD/JPY battles with resistance converging at the 50-day moving average (DMA) and the 100 level
The recent break in overall correlations motivated me to look one layer deeper at the relationships amongst the yen, the S&P 500, and the Nikkei. As it turns out, the day-to-day correlations are relatively weak, BUT the directional biases are relatively consistent with the visual in the first chart above. In other words, while day-to-day there is little correlation amongst these three, they are tending to trend together.
To ease the processing of the historical data, I chose 50-day moving correlations of daily changes. The choice of 50 days is a bit arbitrary but seems reasonable given the importance placed on the 50-day moving average (DMA) for equity prices.
Japanese Nikkei Index Vs US S&P 500: 50-Day Moving Correlation
The chart above shows that since at least 1984, the Nikkei and the S&P 500 have traded in a relatively tight band of correlation from -0.2 to 0.4, very weak correlations. These markets have spent very little time outside of those bands. The two markets have a correlation of essentially zero since the beginning of November despite the strong, simultaneous trends.
For reference, I show the 10-day moving correlation for the Nikkei vs the S&P 500 below. On this shorter timeframe, the correlations are a little higher, but not much. Moreover, the few periods of high correlation (inverse or not) last only for very short periods of time. (The chart only goes back to 2009 for display reasons).
Japanese Nikkei Index Vs US S&P 500: 10-Day Moving Correlation
So, what the eyes see is a general tendency to trend together but NOT to trade together. However, before you think that the 50-day moving correlation hides the correlation or that the trick is to find the correct time period, I have juxtaposed the 50-day moving correlation for the Nikkei vs FXY and the S&P 500 vs FXY. Note the strong inverse correlation between the yen and the S&P 500 for extended periods in 2007 and 2008 and for a briefer period in 2010 (the blue line). These were times of high levels of financial distress. However, this same inverse correlation did not reappear during the severe summer swoon in 2011 or the sell-off in 2012. Perhaps this change in relationship was setting the stage for the yen's current weakness.
Japanese Yen Vs the Nikkei and the S&P 500: 50-Day Moving Correlation
The next two charts make the relationship more clear. Instead of correlation, I look at how often the two indices close their trading days in the same direction over a 50-day period. The closer the number is to 50% of the time, the more random the relationship. The first chart shows only days where the Nikkei ended its trading day with a positive gain. The line shows the percentage of days in the previous 50 days of Nikkei up days where the S&P 500 also closed up. Almost all the data is above the 50% line but the range is also capped around 70%. The overall average since 1984 is 59%.
Percentage of the Last 50 Up Days for the Nikkei Where the S&P 500 Also Closed With A Gain
This next chart shows the same as above but replaces the S&P 500 with the CurrencyShares Japanese Yen Trust (data available back to 2007 in Yahoo!Finance). FXY gains when the yen strengthens against the U.S. dollar. Note that before the big devaluation began, in 2011 and 2012, the Nikkei was quite capable of rising on a day in which the yen also strengthened against the U.S. dollar. Starting in March, 2012, and particularly accelerating in June, 2012, the yen more consistently declined on up days for the Nikkei. By February 19, the 50-day rolling period reached a low point, meaning that the vast majority of up days for the Nikkei featured a declining yen. The big devaluation that began about 50 trading days earlier established the dependency. This chart helps to quantify the recent link between a declining yen and an increasing Nikkei.
Percentage of the Last 50 Up Days for the Nikkei Where the Yen Also Closed With A Gain
Finally, this last chart flips things around a bit and looks at the direction of the close for the Nikkei and FXY when the S&P 500 closes DOWN. There has long been an expectation that the Japanese yen serves as a "safety" currency that traders automatically grab when the stock market wobbles. The following chart shows a much more nuanced picture. The chart shows a nice symmetry over time between the Nikkei and the S&P 500 around the 50% point. However, the attraction of pushing up the yen on S&P 500 down days has slowly waned since 2008. I expect this downward trend to continue as the bias for the yen remains toward weakening. The yen is simply not as attractive any more as "safety" when the central bank behind the currency has become so successful in lowering its value. (I have noted in the past how dangerous it now is to stay bullish for too long on a currency given that bullishness works against the interest of some central banks using the currency to conduct monetary policy).
Percentage of the Last 50 Down Days for the S&P 500 Where the Nikkei Also Closed Down Or Where the Yen Gained
So, overall, while the Japanese yen is on a general weakening trend that appears to support higher prices on the Nikkei and likely higher prices on the S&P 500, the relationships are not reliable on a daily basis. The trends at work must be tracked over weeks and by direction. The risks over that time come from the volatility that can occur along the way. In particular, during the period where the market started roiling (panicking?) over higher interest rates in the U.S., the Japanese yen experienced several days of sudden and sharp bouts of strength where the S&P 500 managed to rally. This volatility is currently coming back down, but I suspect the sudden flares will continue as the adjustments to a new market outlook continue.
Be careful out there!
Additional disclosure: In forex, I am net long the Japanese yen (as a short-term play on potential overhead resistance). I may also initiate a trade, short or long, on the S&P 500 (through SSO) in the next 72 hours.