The Japanese yen and benchmark Nikkei 225 equity index both broke out of significant consolidations last week (Charts 1 and 2). The moves are highly related; in fact, the negative correlation between Japanese equities and the yen has been incredibly consistent over time (Chart 1).
From a quantitative perspective, the Nikkei 225 has demonstrated a reliable beta of -3 with respect to the currency, whereby a 1% decline in the value of the yen results in a 3% gain the Nikkei 225. While it is difficult to objectively demonstrate causality, logically a weak yen leads to greater export competitiveness, and in an export-oriented economy like Japan’s, this is vitally important to corporate earnings. Therefore, yen weakness should be seen as the driver behind strong the Japanese equity market.
There are a number of factors driving the yen lower, with the most immediate catalyst likely being Janet Yellen’s Federal Reserve confirmation hearings in the United States. She is generally viewed as one of the more dovish members of the FOMC, and as Chairwoman of the Federal Reserve, she is expected to maintain monetary stimulus for the foreseeable future. Her eventual placement as the head of the world’s most powerful central bank has supported a new wave of risk-on sentiment, and in that environment the Japanese yen traditionally weakens.
At the local level, Prime Minister Shinzo Abe has been working hard to end the persistent deflation that has plagued Japan for decades. He has overseen unprecedented government bond buying as one of the three pillars of so called “Abenomics.”
Bank of Japan Governor Haruhiko Kuroda is now buying more than ¥7 trillion (approximately $70 billion) worth of government bonds each month, aiming to reach 2% inflation within two years. The market expects that the BOJ will increase the pace of asset purchases next year to compensate for the rise in the sales tax in 2014 to 8% from 5%. The BOJ meets this week, and on Thursday, Nov. 21 may provide new insight into central bank policy.
Comments last week from Japan’s Finance Minister Taro Aso also helped weigh down the yen, as he reiterated the importance of retaining the option of intervening in currency markets should the yen appreciate. Japan is one of the few developed nations to make a habit out of intervening in the currency markets, so Mr. Aso’s comments provide come comfort to yen bears.
Short positions in the Japanese yen and/or long positions in the Nikkei 225 are warranted in light of the strong breakouts, with stops at 14,500 for the Nikkei and 101.50 for the yen (basis December futures) should the breakouts fail.