In the last section I have described how equities markets are correlated to each other. But not only the performance of stocks affects other equities. In this chapter I want to focus on one of the most interesting currency pairs – USD/JPY and its positive correlation with equities markets, mainly U.S indices. The Japanese Yen is one of the “majors” – the most popular and liquid currencies in the world. Its popularity mainly comes from the fact that it is used in carry trade transactions. In carry trade investors borrow low-yielding currency (in this case the Japanese Yen since interest rates in Japan currently are at 0.5%), but higher-yielding currency (US dollar) in order to purchase more risky financial instruments (U.S stocks). That is how the relationship between equities markets and currency markets can be seen the best.
When risk aversion decreases, investors are more willing to take risks. They borrow Yens, purchase dollars with them and invest those dollars in American stocks. In this process, the USD strengthens against the Yen and the USD/JPY increases. Along with that, stock indices gain. In the opposite case, when risk aversion increases, investors liquidate their investment in stocks. They have dollars on their hand but have to pay back they Yens they have borrowed, so they buy Yens. The USD/JPY declines as well as stock markets. This relationship between the USD/JPY and the U.S equities markets is pictured below. Graph 1 shows the Dow Jones Industrial Average during the second week of January 2008. Graph 2 represent the USD/JPY quotations during the similar time period. Please note that both graphs move in the similar direction.
In my opinion, the USD/JPY is the best currency pair to track global risk aversion. If the situation of stock markets is improving, the USD/JPY is likely to be increasing. It means that more carry trade transaction are being carried out. The opposite happens when the situation on the equities markets worsens. Indices decline and investors begin closing carry trade transactions causing the USD/JPY to decline. Often times when analyzing stock markets I tend to take a look at the USD/JPY graph. It helps me understand what is going on and what can I expect in the near future.
Feel free to contact me with any question or comments.
Adam Narczewski
X-Trade Brokers Dom Maklerski S.A.
adam.narczewski@xtb.pl