Wanna know where stocks are headed? Watch the Japanese Yen.
If you follow our research, it has been no secret that the Yen has been driving the stock market's ups and downs.
In a research piece I did on March 26, it was noted the Yen was strengthening and taking the equity markets down with it. That article showed how the Yen was a leading indicator to the U.S. equity markets. This proved itself as the markets followed the Yen's strength and embarked on a 4% pullback since.
Should we expect more Yen strengthening (CCY:JPY=X) and thus market declines ahead?
Japanese Inflation or Deflation?
This past weekend Bloomberg ran an article discussing the rising tension among the Japanese public concerning inflation. Estimates are that April's inflation rate could hit as high as 3.5%, which on the surface suggests the Yen will weaken, not strengthen, from here.
Out of Tokyo, the Director of Economic Research at the NLI Institute, explains, "households are already seeing their real incomes eroding and it will get worse with faster inflation." After all, wages declined for a 21st straight month as reflected in consumer sentiment which is now the lowest it has been since September 2011.
Economists are now predicting a 3.35% annualized economic contraction for the next three months beginning in April. This is more inline with continued deflation and what may actually drive the Yen stronger.
The consumer is not accepting rising prices that are a result of the levied taxes government has required businesses to pass onto the consumer, and Japanese GDP is now going to suffer greatly from it (listen up deficit doves - this means you Paul Krugman).
The Japanese situation should be teaching us that the government can only do so much. At some point the public's actions are much more important and necessary. The aging Japanese public is choosing deflation over inflation, and that implies a continued strengthening of the Yen.
Price Is the True Leading Indicator
Along with other analysis, the following chart has been included in our Technical Forecast numerous times over the past few months. On 3/7 the hammer bottom candlestick at Fibonacci and trendline support had us recommending staying long the Yen. Then on 4/6, the red trendline support held perfectly again as the Yen found more buyers. We reminded our readers, "Price should continue to rally here."
We also reminded readers that "the Yen's chart below suggests a continued rally in the future. This suggests the equity markets will continue lower over the coming weeks."
On 4/6 the S&P was trading at 1865. The continued strengthening of the Yen to $98 sent the equity markets down below 1820 as the extreme correlation between the two continues through today.
So, what's next?
The chart suggests after a short-term consolidation over the next few days, a longer term breakout of the bullish flag pattern (shown by the red trend channel) should be next. This implies the Yen will continue to strengthen, and the equity markets are not finished with their declines.
If the Yen can pull back to retest support at 95, though, the equity markets will have a chance to make another new all time high. But, make no mistake, the Yen will continue to be what pulls the equity markets' strings and ultimately decide its fate.
Disclosure: No positions.