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

by Daniel Putnam | August 7, 2013 1:24 pm

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:


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.

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