What the Euro/Yen Ratio Means for Traders

One of the most important undercurrents of stock prices is currency differentials

   

One of the biggest concerns last week was over the ratio between the euro and the yen, and between the euro and the dollar. As expected, the European Central Bank left interest rates unchanged and did not signal the likelihood of any near-term change in its monetary policy or unconventional measures.

However, there was one key issue in the value of the euro. While the central bank said that the euro’s recent strength fit with the return of confidence, its statement highlighted the exchange rate as a risk to the inflation outlook. The euro  came under pressure on Thursday, and that pullback was also cited as a factor behind the more lackluster tone in U.S. equities and risk appetite.

Currency Differentials

2 25 13 xeu 300x251 What the Euro/Yen Ratio Means for Traders
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If that doesn’t make sense to you, let me explain a moment. One of the most important hidden undercurrents of stock prices is currency differentials. Generally speaking, when global investors take risk, they sell yen and buy euros. This pushes the euro/yen ratio higher.

 

This can go on for a while without consequence. But ultimately, currency differentials tend to reverse on a dime when one side says “uncle.” In this case, the Europeans are willing to let the Japanese yen fall to help with that country’s exports. But at a certain point, the yen becomes so weak relative to the euro that it heavily impacts eurozone companies’ ability to compete on price. That happened today, very subtly, when the ECB said that a further advance in the euro would do much more harm than good.

When currency ratios reverse, they usually go in the opposite direction for a prolonged streak. And the interesting thing is that most (but not all) of these reversals in euro/yen over the past 12 years have preceded big declines in U.S. stocks. It happened in 2007, again in 2008 and most recently in the spring of 2011, as shown in the chart above.

Is a Reversal on the Way?

My sources in the currency-trading world are saying that the recent extreme spike higher in euro/yen (green tint in the chart) is probably not sustainable. If it blows off and reverses, risky assets like U.S. and European stocks may well follow.

I’m just saying it is something to watch, and if it tops and reverses, and stocks start to follow, then it won’t be a random coincidence, and you will know to batten down the hatches for at least a few weeks. We would take off our riskier trades, and focus more on shorting and puts. There are lots and lots of great candidates on the short side after the recent rocket ride higher.

If that happens, and it climaxes lower, ultimately we would stop shorting and look for a climactic event. It would probably take less than four to six weeks. And then , looking forward, that would be a great new entry point in stocks like home-builders, media conglomerates, financials, staples and the like that have led the recent rally.

A one day reversal, as we saw on Thursday, is not enough to initiate this sequence of events.

InvestorPlace advisor Jon Markman operates the investment firm Markman Capital Insight. He also writes a daily swing trading newsletter, Trader’s Advantage which aims to capture profits of 15% to 40% and often as much at 100% to 200% in less than 90 days. 

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