When Equity markets are lower and risk aversion is in place, then the higher yielding currencies such as Aud, Gbp, and Nzd tend to be the first to get liquidated. An overall rule of thumb to follow:
- Equity markets higher = Yen lower
- Equity markets lower = Yen higher
On the days that the link is lost most traders understand that the follow-through may be volatile. This correlation is incredibly strong over a period of time.
| S&P 500 3 Year Chart vs. Eur/Jpy Chart |
Data Source; MetaTrader4 and Bloomberg
Equity markets also known as Stock markets are the most diverse markets in the world and therefore are an integral part of any country’s financial system. This importance ensures tight regulation from government agencies when compared to other markets such as Futures and Foreign Exchange.
The actual economic impact from Equities stems from the need of corporations and businesses to raise cash, and this then leads to speculation by investors. The primary market is made up of large banks and investment houses whose function is to assess a company’s health and then the financial market’s desire to own such a company. After an initial assessment is made and approved, the primary lender purchases a large sum of shares from the corporation. It then displaces these shares in the open market (exe. NYSE) through an initial public offering.
It is a common misconception to think that a corporation will benefit monetarily from a strong IPO. The main financial reward at that point goes directly to the underwriter, who then needs a secondary market (stock exchanges) to ensure that the subsequent flow of capital will not be hampered.
The secondary market allows for the free flow of capital into the primary market, a market that at one point in time was responsible for much of the capital needed to create such companies as General Electric, IBM, and Microsoft. It will be there to perform the same function for tomorrow’s business leaders as well.
Last but not least it is the predictability of Stock markets as a leading indicator. Nine out of the ten last recessions where preceded by a decline in stock markets within an average of six months. Predictability also works for the upside as well; Commodity stocks tend to turn higher before the actual Commodity prices, in average by three months.
The three most important global Equity markets are: Asia (Japanese Nikkei 225), Europe (German Dax), North America (US S&P 500).
The fact that Equity markets do a great job of raising capital and some times a great job in losing speculator’s capital, ensures an attachment to the Forex world and in general creates the correlation with the Japanese Yen.
When Equity Markets are boisterous, have a positive cash flow and good sentiment, Traders are prepared to include an element of risk in their portfolio. As such they will diversify their Equity holdings to include the search for overnight interest payment or Swap Interest. This is achieved by holding through 5pm EDT a currency Long that has a higher regional Interest rate than the currency on the other side of the Pair, for example Long AUD/JPY. That trade pays 6.25% Interest for the Long Aussie, less 0.5% Interest for the Short Yen; The Carry Trade.