In tweets and various posts, I have harped on the renewed strong relationship between yen strength and market weakness. In "Weakness in the Japanese Yen Is Over for Now, Part Two", I updated an overlay of the USD/JPY, the U.S. dollar vs. Japanese yen currency pair, and the performance of the S&P 500 (SPY) on key days of yen strength:
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USD/JPY finally cools off
Source: FreeStockCharts.com
After quantifying the specific correlations at work between USD/JPY, the inverse of the Rydex CurrencyShares Japanese yen Trust (FXY), and the S&P 500 , I discovered a few surprises that I believe could imply sustained weakness in the stock market going forward.
I calculated rolling correlations between USD/JPY and the S&P 500 using 3, 5, 10, 20, 50, and 200-day periods. I removed the 3, 5, and 10-day rolling periods because rapid swings in these values are not too useful for my purposes here. I also dropped Sunday's values for the USD/JPY since the S&P 500 does not trade on Sundays.
Each point in the chart below shows the correlation for the last 20, 50, and 200 days (see the legend to map the lines to the proper rolling period). I used data from FreeStockCharts.com, but it only provides currency data going back to September 2, 2010. I believe this is sufficient given more recent data typically gets a lot more weight than old data in currency trading.
Note that when the USD/JPY goes higher, the U.S. Dollar is relatively more valuable than the Japanese yen. So, a high correlation (towards 1.0) between USD/JPY and the S&P 500 means that the S&P 500 tends to go up when the U.S. dollar is relatively stronger than the Japanese yen and vice versa. When the USD/JPY and the S&P 500 have a negative correlation, the S&P 500 tends to go up when the U.S. dollar is relatively weaker than the Japanese yen and vice versa.
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Until very recently, the correlation between USD/JPY and the S&P 500 was strengthening very sharply
Several notable features of these relationships stand out to me:
- The convergence of extremes is very rare for the rolling correlations.
- The 20-day and 50-day have converged extremes three times since September 2. Each time has corresponded to a significant change in the prevailing trend in the S&P 500: Feb. 4th, 2010 convergence preceded the local top in the S&P 500 on Feb. 18th; April 12th, 2010 convergence preceded the lasting top in the S&P 500 on May 1st.
- The current convergence corresponds with a stall in the S&P 500 upward trend and this time includes an extreme in the 200-day rolling correlation.
- The correlation between the USD/JPY and the S&P 500 moved from one extreme, a strong inverse relationship, to another extreme, a strong direct relationship, in just the last 2-3 months.
- The correlations spend little time at the extremes of the range, and the rapid drop in the 20-day correlation over the last two weeks suggests that this strong relationship is coming to an end.
- The 20-day and 50-day correlations last reached recent heights exactly one year ago.
Given the S&P 500 last peaked on May 1st of last year, it is very tempting to wonder whether the current ending of the high correlation is signaling another imminent top in the S&P 500. Immediately after the 20-day peaked at extremes on March 2, 2012, the S&P 500 sold off sharply for two days. As the 20-day has retested that peak along with the 50-day rolling correlation achieving extremes on March 13th AND the 200-day returning to its earlier extreme, the S&P 500 has gone nowhere (after printing a major breakout).
I zoomed in on the last eight months of trading, starting from the August swoon, to generate a good visual on how the S&P 500 has changed with changes in its rolling correlation with the USD/JPY currency pair.
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The S&P 500 has stalled as the rolling correlations have reached extremes together
The current data suggest that any relationship between these correlations and the subsequent behavior of the S&P 500 represent sufficient conditions but not necessary ones. The question to ask is why would or how could such a high correlation be related with an imminent change in the prevailing trend in the S&P 500? I like to think of these dynamics as representing a reversion to some "norm." It just so happens that the yen's current weakness is similar in scale to its weakness after G7 countries intervened to help Japan weaken its currency following the tsunami and Fukushima nuclear power plant disasters. A reversal of this sharp move with a strengthening yen should coincide with a retreat from the "risk on" bias in the stock market.
In the coming weeks and months, I hope to draw a richer set of relationships from these data as well as monitor the on-going dynamics more closely. Although the current convergence of extremes in the USD/JPY vs. S&P 500 rolling correlations is a rare event, recognizing its implications may offer an extended window of opportunity. In particular, these observations will likely force me to adjust my current aggressively bullish bias.
Be careful out there!
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FXY over the next 72 hours.
Additional disclosure: I am also long USD/JPY as part of a small hedge of on short GBP/JPY
