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Attention, U.S. Stock Investors: Turn Your Focus to the Yen

The rising yen might be a signal that a market downturn is near


The Japanese yen is on the move again, and investors should sit up and take notice.

Throughout 2013, the yen has been a leading indicator for the direction in U.S. equities: When the yen falls, stocks rise; when the yen rises, stocks weaken. But thus far, the moves in the yen have preceded the reaction in stocks by anywhere from several days to several weeks. With the yen now in rally mode, what does this mean for equities?

If history is any indication, it might be telling us that another downturn for the U.S. market is in the offing.

The Yen as a Leading Indicator

A look back at the year-to-date period shows that the yen has accompanied or preceded all three major phases of U.S. stock market performance, which should give investors a reason to consider whether a fourth stage is now at hand:

  • Stage 1: In the first four-plus months of the year, the prospect of extremely aggressive quantitative easing by the Bank of Japan fueled extraordinary weakness in the yen. From Dec. 31 through Friday, May 16, CurrencyShares Japanese Yen Trust (FXY) was hit for a loss of 16.1% on concerns that the rampant money-printing would devalue the currency. During this time, the U.S. market rallied by more than 17%.
  • Stage 2: The short-yen trade began to unwind the following Monday — May 20 — then accelerated once Treasury yields shot up in the wake of Federal Reserve Chairman Ben Bernanke’s comments about beginning to taper quantitative easing. Notably, the uptick in FXY preceded the subsequent downturn in U.S. stocks by two trading sessions, as the S&P 500 didn’t top out until midway through the day on Wednesday, May 22.
  • Stage 3: From its May low, FXY began a rally that would see it advance 9.1% by June 14 before it began to lose steam. But again, the yen provided a preview of what was to come in U.S. equities: The S&P didn’t touch its low until six sessions later — June 24 — before embarking on its most recent up-leg.
  • Stage 4? On July 5, FXY again touched a low — closing at $96.70 — and began to rise again to its current level above $101. The gains, which were slow at first, have accelerated in recent days. It took longer for the U.S. market to follow suit this time, but stocks have now declined in three straight sessions from Aug. 5-7.


Now What?

Currency performance is fickle, and correlations are even less reliable. Nevertheless, the relationship between the yen and U.S. equities is well-established in 2013. In fact, the S&P 500 has a negative correlation of -0.86 with FXY. Given that -1.0 indicates perfectly negative correlation, this indicates near-inverse trading characteristics between stocks and the yen.

Why does this matter now?

The rally of the past few days has caused FXY to move above the trendline it has established in 2013. The next resistance point is its June 20 intraday high ($104.20), and beyond that its 200-day moving average (currently at $106.29). This leaves plenty of room for further yen appreciation in the weeks ahead, which likely would take a toll on U.S. stocks — or at least cap the upside.

Although seemingly unlikely, such a move could indeed occur here. The Bank of Japan has thrown everything it has at the economy to combat deflation: On a proportional basis, the absolute size of Japan’s quantitative easing is more than 80% that of the United States’, yet its economy is just a third of the size. Despite this, the yen is well off of its lows of the year and is even with where it stood four months ago. This indicates a lack of confidence in the ability of the central bank to continue deploying its policy in an effective manner.

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From a technical standpoint, U.S. equities can sustain some damage even if the yen rally continues. The S&P 500 continues to put in higher lows, and it sits 4.9% above its lower trendline at 1,610. This is on par with the 5.2% gap that existed prior to the last yen rally in mid-May, indicating a similar capacity to withstand adverse developments at this stage.

Still, the trendline provides a defined point at which any downturn would become more worrisome.

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The Bottom Line

There’s no guarantee that the yen will continue to rise, as a simple comment from the Japanese government or central bank would be enough to derail the rally. Still, the yen has acted as a leading indicator on multiple occasions so far in 2013.

For this reason, investors need to stay on their toes as long as the yen is marching higher.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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