What role does the currency play in market movements?

Following Monday’s strengthening of the Japanese yen, several hedge funds have started to dump Japanese equities, signaling the end of popular long positions in the country.

Could it be that the direction of the yen is even more critical than that of the economy for the markets?

It is hard to say whether it is more crucial, but it is evident that Japanese stocks have become exceptionally sensitive to yen movements over the past two years. In simpler terms, where the currency goes, so goes the market.

It should, therefore, come as no surprise that after the yen strengthened earlier in the week, the Nikkei 225 index also experienced a correction.

Similar moves have already been observed, especially ahead of the Bank of Japan’s March meeting, when the regulator was expected to announce a monetary policy review.

How much does the Nikkei get affected by the yen moves?

According to some estimates, a 1% rise in the Japanese currency could cause the blue-chip index to fall by about 2%. However, this effect tends to soften over time.

For example, although the USDJPY rate has risen by around 0.76% since the start of the week, the Nikkei index has only increased by 0.36%. Therefore, it is clear that relying solely on the yen’s movements to invest long-term in Japanese stocks can be risky.

As elsewhere and with any other instrument, it is impossible to guarantee the prediction of the direction of movement using only one indicator. It is necessary to look at the big picture.

So why should the index go down when the yen strengthens?

The rising yen puts pressure on exporters’ earnings, which are crucial to the Japanese economy, given its heavy dependence on international trade.

Looking ahead, the unwinding of bearish yen bets by hedge funds and asset managers could strengthen the Japanese currency to 139 against the dollar by the end of 2024.

In addition, further rate hikes by the Bank of Japan or government interventions could also favor the country’s currency. Another positive factor could be the Fed’s dovish rhetoric.

What should we pay attention to?

The Bank of Japan will release its current account balance forecast tomorrow, which could help determine whether the authorities intervened in the foreign exchange market on Monday.

If they did, it suggests that the regulator is willing to intervene when necessary, and therefore, bearish investors should exercise caution. If not, the yen’s slide could resume.

The problem is that spending foreign exchange reserves is only temporary, which is unlikely to lead to a turnaround. In the end, the government will simply deplete the funds.

This article was written by FL Contributors at www.forexlive.com.