In Wednesday's Daily Market Commentary webinar, our analysts discussed the importance of using exchange rates as an early warning sign of bearish moves in the stock market. Stock investors may not be generally aware that the Japanese yen and the U.S. stock market have a high level of inverse correlation. If the yen is rising, there is a good chance that stocks will languish or fall. Conversely if the yen is falling in value, stocks will likely be rising.

The Yen/Stocks Relationship Is Due to Risk Expectations

The negative correlation between these two assets is because many investors borrow yen (similar effect as shorting) to buy higher-yielding assets like U.S. stocks. Therefore, if there is a lot of yen borrowing (shorting), chances are good stocks are rising and the currency is falling. The yen is also a so-called “safe haven” investment during times of geopolitical risks, which tends to boost its value and while stocks are hurt by uncertainty.

The relationship isn’t a perfect mirror image, which is why traders find it useful. If the yen starts to rise in value (normally bearish for stocks) the reaction in the market may be a little delayed and this signal can be a valuable warning, which happened in January 2018 prior to the February market correction. Similarly, if the yen falls in value while stocks are flat or a little bearish, it’s a good signal that markets may find support in the short-term and head higher.

This is an important concept to understand this week as investors worry about the potential for financial contagion from Turkey’s currency crash spreading to Italy and Greece. Stocks were choppy on Wednesday but ultimately closed higher after a bullish Fed-minutes report. However, the yen didn't give up its gains as stocks recovered, which is a little worrying. One day doesn't make a trend, but if the yen continues to rise, investors should be on the alert.