While all eyes are on Russia’s next move, my eyes are focused farther east, to Japan.
Much has been made in the media about the sanctions the U.S. is placing on Russia and many smart people are scrambling to figure out how these events will affect exports, imports, prices, and ultimately financial markets around the world.
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The situation with Russia no doubt is very serious, but when it comes to the financial markets there is still just one major driver; the Yen.
Causation or Correlation?
When discussing correlations, even extreme ones, there is always a question of which particular data point is driving which. Essentially, it can be a chicken and egg scenario where an investor is not sure whether A is causing B or B is causing A. Sometimes it doesn’t matter as long as the trend and its implications can be recognized. After all, do we really need to know how the car engine works to drive home?
Check out the chart below of the Japanese Yen (NYSEARCA:FXY) shown in blue with the U.S. Stock Market shown in black (NYSEARCA:RSP).
There are a few things happening on the chart that merit attention:
1) Generally both markets trend together. This is shown by the overwhelmingly positive correlation in the bottom portion of the chart
2) That correlation has often approached 1.0, showing an incredibly strong relationship between the Yen’s weakness and the S&P 500’s strengthening. It also suggests the S&P’s fate is likely tied to the Yen’s, or vice versa
3) Whenever the Yen (in blue) has fallen in price (strengthened in value) the S&P was not far behind it in declining in value. This is shown by the red squares. Every meaningful S&P top of the last year was preceded or coincided with a bottom in Yen weakness
The Gorilla in the Room
The New York Stock Exchange has traded about $40 billion worth of stock each day on average so far in 2014. The Nasdaq (NASDAQGS:NDAQ) market has also been trading around $70 billion a day. Together these two exchanges make up the bulk of the U.S. equity markets (NYSEARCA:SCHB) and trade around $110 billion worth of equity each day.
In contrast, according to the Bank of International Settlements, the foreign exchange markets trade over $5.3 trillion each day (NYBOT:DX-Y.NB). Of that $5.3 trillion, the Yen (NYSEARCA:YCL) accounts for an estimated 11.5% of the total amount resulting in around $600 billion of Yen traded daily.
The Yen trades over five times the amount of U.S. equities and puts in perspective just how massive the foreign exchange markets are compared to the equity markets.
Given the size of the Yen and foreign currency markets, it is highly likely the Yen is the gorilla in the room and a much larger factor in the equity markets than is given credit by the mainstream media and analysts.
In addition to being the Goliath to the equity market’s David – based on pure dollars traded – a look at the chart shows that the Yen also leads the equity markets, often topping a few days before the equity markets. Every time the Yen has started to strengthen the equity markets have followed it lower.
What this means is if you are bullish the U.S. equity markets, then you must also be bearish the Yen and most certainly expect more weakening in that currency. Otherwise, history does not support a continued rise in the equity markets.
If the Yen continues its recent strengthening trend, it is likely the U.S. equity markets have again found another top.
The ETF Profit Strategy Newsletter keeps you ahead of the macro trends in all the asset classes. Check out our bi-weekly Technical Forecast and why we think the next move for the Yen is likely to be continued strength. This implies the S&P has again likely reached a tradable top.