As financial markets become ever more correlated, it becomes increasingly important for traders to use every bit of information at their disposal. One way to do this is by using the movement in other markets to help us predict the future path of the market we are interested in. The first step is to find assets that are highly correlated with the products we want to trade.
We have been talking a great deal lately about the notion of the Carry Trade, wherein a trader will finance a leveraged position in the S&P 500 by borrowing a cheap currency like the Japanese Yen and selling it for US Dollars used to purchase the stock index. The influence of the carry trade exerts a strong correlating force between the Yen and the stock market, as we can see of this chart from of the last two weeks:
The relationship between the Yen and the US stock market is so strong in fact that you can predict the future path of the stock market from the past movement of the Yen. The following chart shows a scatter plot which shows the relationship between two variables
- On the Y-axis (vertical) represents the NEXT 2 HOUR CHANGE in the S&P 500 futures
- The X-axis (horizontal) represents the PREVIOUS 2 HOUR CHANGE in the Yen futures
In layman’s terms this means that the past movement of the yen predicts the next move the stock market will make, to a degree. Statistically, the Yen explains a massive percentage of the movement in the stock market, but as you can see there is some variable so there are definitely other factors involved as well. However, not looking at the Yen puts you at risk of being taken by surprise by big market moves. In general the data indicates:
- When the Yen has strengthened, it exerts a negative effect on the S&P 500 in the future
- When the Yen has weakened, it exerts a positive effect on the S&P 500 in the future
As long as the Yen stays weak, expect continued outperformance from the stock market. At times when the Yen strengthens we can experience quick declines in stocks so keep one eye on the Yen at all times to help time entries/exits.