Anyone trading the Nikkei (EWJ) or USDJPY (FXY) must surely know the correlation between the two markets is strong. A falling Yen equals rising Japanese equities. But recently something strange has happened.
Breakdowns in traditional correlations tell us something is changing in the market. But what?
The Fundamental Bond
The primary driver of the Nikkei / USDJPY correlation is deflation. The worse the Japanese deflation problem gets, the more monetary and fiscal stimulus is needed.
A break-down in the correlation suggests reflation. It is a common theme in the last 12 months, and the hawkish shift in some central banks is well known. Is it moving to Japan?
The simple answer is 'no'. Or at least there is no evidence, yet.
The uptick in inflation is very small given the amount of stimulus. And it is certainly not significant enough for the Bank of Japan to change direction. In fact, on the annual anniversary of the launch of its yield curve control measures, members voted 8-1 to keep the current policy intact.
And in case you think the one dissenting voter is shifting hawkish, actually Goushi Kataoka voted against yield curve control on the grounds that current easing is insufficient.
For now, he is a lone voice, but Nomura expect his view to gather support,
‘From a longer-term perspective, we think a resurgence of expectations for further easing is likely, given the substantial risk (noted by the BOJ itself) that inflation could fall below the BOJ's forecasts, with inflation expectations slow to rise. We think Mr Kataoka's opposing vote could even be seen as laying the groundwork for such a resurgence.’
Reflation is in its infancy in most countries, and is still a distant hope in Japan.
So if reflation is not the cause, what is?
The easy and ever so obvious view is that if the correlation break down in temporary that USDJPY will catch the Nikkei up by breaking higher. But this both ignores what is really happening now in the world and what has happened before. There is a good reason why the Nikkei has broken the 2015 high and prompted Nick Leeson (the cause of Barings collapse in 1995) to tweet "Nikkei225 at highest level since 1996 - probably not far off my break-even point. If only they'd waited".
Despite continued new highs in US markets, real money is flowing out of the most overvalued indices in the world, the US (based on comparative PEs) and is looking for a home.
Surprisingly, since Donald Trump's election US markets have actually been falling relative to the global index.
This disinvestment has been reflected by the 10% fall in the US dollar (UUP) since April when President Trump wished it lower.
The reason why USDJPY appears relatively weak over the last week and the Nikkei rampant is because USD denominated funds are buying the Nikkei, (that is, buying JPY and selling their USDs).
Normally they would hedge that foreign exchange risk by buying USDJPY. But as yet they are not - itself a reflection of risk aversion to the dollar. Should USDJPY start breaking the 113.40-114.55 resistance area on further Nikkei strength this may prompt them to hedge and cause the catch up that many regression analysts are predicting.
However, there are 2 sides to the correlation coin. What if USDJPY fails to rally because those disaffected by the USD stay away? Indeed what if the Nikkei breaks back below 21,000?
This is more of a contrarian view, but is something we see as more probable.
The sentiment driven blow off rally in global indices has largely ignored fundamentals, but this type of action is temporary. Such a breakdown in correlations reflects a market which is trading on emotions such as fear and greed and serves as a warning.
The breakdown in a long standing correlation is always interesting. In the case of the Nikkei / USDJPY, it seems disconnected from fundamentals (i.e. reflation) and more related to a sentiment driven surge in demand for equities. This tells us the divergence is likely temporary, and contrary to some views, the Nikkei could reverse and fall in line with USDJPY rather than vice versa.
This article was written by
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.