Yen is weaker and Japanese equity futures notably higher following a landslide election victory for Japan Prime Minister Shinzo Abe which theoretically ushers in yet more easy monetary policy. USDJPY has jumped above 114.00 in early trading, sending NKY futures up almost 1% in the pre-market.
If this equity rise holds it will mark the 15th consecutive gain for the Japanese market - breaking the 1961 record of 14 straight days to become the longest winning streak in Japanese stock market history.
Nikkei 225 is at its highest since Dec 1996.
Meanwhile, much has been made recently of the decoupling between USDJPY and the Nikkei 225
However, this chart masks a closer relationship between USDJPY and the relative performance of Japanese and US equities.
So there really is no regime shift.
What are the drivers of this persistent negative correlation between the yen and Japanese equities and which flows supported this negative correlation this year?
On Friday, JPMorgan presented three fundamental explanations to justify the link between Japanese equities and the yen.
One typical explanation is that the yen, being a major funding currency for the world, should rise in a risk-off equity environment and vice versa. But this argument is not supported by the fact that there is much lower correlation between the yen and global equities. It is also not supported by the structural break in the correlation between Japanese equities and the yen shown in the chart above. The yen was the most prominent or sole funding currency before the financial crisisof 2007/08. After the financial crisis the yen was joined by the dollar and later by the euro as funding currencies. So if anything the negative correlation between equities and the yen should have been even more negative before the financial crisis. But the opposite happened. The negative correlation only intensified after the financial crisis.
A second explanation, with causality running from yen to Japanese equities, is that a weaker yen has a positive impact on corporate profits inducing equity investors to buyJapanese equities and vice versa.
A third explanation is that Abenomics was always thought of as a combined trade for overseas investors: buy Japanese equities and sell the yen. And reverse, i.e. sell Japanese equities and buythe yen, when Abenomics wanes.
But JPM notes both of these last two explanations have a problem: why does the yen not go up as foreign investors buyJapanese equities? In principle when foreign investors buy or sell Japanese equities currency-hedged there should be no currency impact. And when foreign investors buy or sell Japanese equities currency unhedged there should be in fact a positive correlation between the yen and Japanese equities. What are the circumstances then under which we have a negative correlation between Japanese equities and the yen?
We previously presented three flow circumstances:
1) If a foreign investor (buyer) purchases Japanese equities currency-hedged from another foreign investor (seller) who was long yen already (i.e. the seller owned these Japanese equities currency unhedged before), the net market impact would be an up movein Japanese equities and a down move in yen.
2) If a foreign investor (buyer) purchases Japanese equities currency-hedged from a Japanese investor (seller) and this Japanese investor uses the proceeds to purchase foreign equities currency-unhedged, the net impact would also be an up move in Japanese equities and a down move in yen. This flow appears to have taken place since mid-September. Foreign investors were buyers of Japanese equities, at the same time as Japanese investors sold domestic equities and as Japanese investors stepped up their purchases of foreign equities. But since September, the purchases of foreign equities by Japanese investors were smaller in magnitude relative to the purchases of Japanese equities by foreign investors. So the negative impact on theyen from the former flow was more muted relative to the positive impact on Japanese equities from the latter flow.
3) Another flow example is related to dynamic hedging by existing holders of Japanese equities, Existing foreign holders of Japanese equities could have unwound previous FX hedges in response to equity price declines in recent months, even if they did not sell any Japanese equities themselves. This is because equity investors tend to dynamically adjust their FX hedges to match the size of the hedges to the value of their equity holdings. So as the price of Japanese equities goes down in local currency terms, these foreign investors cut some of their previous FX hedges, pushing the yen up in the process. The opposite flow takes place in periods of Japanese equity appreciation: existing foreign holders of Japanese equities have to increase the size of their FX hedges to match the increased equity values, pushing the yen down in the process.
This dynamic hedging flow suggests that there should be an even stronger correlation between the performance of the yen and the absolute performance of Japanese equities in local currency terms, relative to the correlation between the yen and the relative performance of Japanese vs. US or global equities. But the two charts above show that the opposite happened this year. The correlation between the yen and the relative performance of Japanese vs. US equities has been stronger than the correlation between the performance of the yen and the absolute performance of Japanese equities. This suggests the above flow stemming from dynamic hedging by foreign investors of existing Japanese equity holdings, has likely weakened this year.
So from the above three flow circumstances, it is the second one that appears to offer the best explanation of what happened since September in the Japanese equity/yen space.
So, following the recent buying, how overweight have foreign investors become in Japanese equities?
So in all, it appears that overweights in Japan have been focused mostly among leveraged overseas investors including CTAs, making Japanese equities vulnerable to an unwind of some of these positions in the near term. Non-leveraged institutional investors or retail investors are rather neutral.
To conclude, JPMorgan finds no reason to believe that the historical negative correlation between Japanese equities and the yen has broken down. The relationship between Japanese equities and the yen has been closely aligned this year if one looks at the relative rather than the absolute performance of Japanese equities.
More recently, since September, the purchases of foreign equities by Japanese investors were smaller in magnitude relative to the purchases of Japanese equities by foreign investors. So the negative impact on the yen from the former flow was more muted relative to the positive impact on Japanese equities from the latter flow. Going forward, overseas leveraged investors present the main vulnerability for Japanese equities, in our view.