Nikkei correlation: Possible plummet in USD/JPY

Historically, the performance of USD/JPY has provided a reliable proxy for global equity markets and risk assets as a whole.

This correlation makes sense: when traders are feeling more optimistic (high risk appetite), they tend to buy stocks and sell yen to fund carry trades in higher-yielding currencies, but when they are more pessimistic (risk averse), traders have to rewind these trades by buying back yen and selling equities.

Beyond the general risk relationship, the correlation between USD/JPY and Japan’s Nikkei 225 index is further strengthened by the index’s heavy weighting in export-oriented companies. When the value of the yen rises (USD/JPY falls), Japanese exporters see reduced demand from overseas buyers.

On the other hand, a fall in the value of the yen (USD/JPY rise) makes Japanese goods “cheaper” for foreigners, boosting Japanese sales and driving Japanese shares higher. As the chart below shows, this correlation has been extremely reliable over the past year, though of course there is no guarantee it will continue into the future.
 

Perhaps the most obvious characteristic of the below chart is the major divergence over the last four months. Since January 21 (four months ago), the Nikkei has fallen 9.7% while the USD/JPY has only pulled back 2.7%. While currencies rarely move as much as stock markets, the current value of the Nikkei suggests that the USD/JPY should be trading closer to 99.00 based on the recent correlation, rather than its current level around 101.40.

Admittedly, looking at intermarket correlations is only one crude way to estimate a currency pair’s value, but the fundamentals and technicals are also starting favor more strength in the yen.

Earlier today, the BOJ statement showed that the central bank is growing more optimistic about the economy’s ability to weather the sales tax hike.  As a result, traders are starting to ponder whether the BOJ will have to increase its QE program at all this year, a step that appeared to be a foregone conclusion at the beginning of this year. Finally, my colleague Chris Tevere covered the technical outlook for the pair in-depth yesterday, concluding that a break below the 2014 low near 100.75 could potentially take the pair “considerably lower over the ensuing months.” The pair has bounced from that level thus far today, but traders of all stripes will definitely be keeping a close eye on USD/JPY 100.75 over the next week.

About the Author
Matt Weller

Senior Technical Analyst for FOREX.com. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, Matt creates research reports focusing on technical analysis of the forex, equity, and commodity markets. In his research, he utilizes candlestick patterns, classic technical indicators, and Fibonacci analysis to predict market moves. Matt is a Chartered Market Technician (CMT) and a member of the Market Technicians Association. You can reach Matt directly via e-mail (mweller@gaincapital.com) or on twitter (@MWellerFX).

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