The Theoretical Basis For The Yen-Stock Market Link

It is a well-established empirical fact that whenever global stock markets fall, the yen and to a lesser extent also the Swiss franc tends to rise in value versus other currencies while for example the dollars of Australia and New Zealand tends to fall against other currencies. In recent months, the U.S. dollar has also started to move similarly to the yen. Of course, like every other empirical pattern, the correlation is not perfect (there have been brief periods when the yen has declined in value even as stock market values have declined), but most of the time it holds and the correlation can certainly be characterized as significant.

But while this empirical pattern is well-established, no real satisfactory explanation for it exists. When thinking about it, I first thought this was simply the result of technical factors, which is to say "quant" traders acting on historical relationships and buying yen whenever the stock market fell. Surely the relative attractiveness of Japanese assets and goods versus Australian assets and goods had nothing to do with the movements of global stock markets, I thought. But when thinking through the subject, I realized that there is in fact one reason to believe that Australian assets will be relatively less attractive compared to Japanese assets if stock markets falls.

I hinted at the reason in my previous post on the Canadian dollar, namely that if interest rates are generally trending downwards, then this will make currencies where interest rates can't fall further (because they are already zero or close to zero) more attractive. Since I prefer stating economic theoretical propositions in the form of verbal logic as opposed to Mathematics I will state this reasoning in the form of formal logic (Aristotelian syllogisms).

Premise: Interest rates are trending downwards when stock markets fall.

Premise: Certain countries had interest rates at or close to zero to begin with.

Premise: Interest rates can't fall below zero.

First conclusion: From these premises it follows that differences in interest rates will fall between high interest rate countries and countries with interest rates at or close to zero whenever stock markets fall.

Additional premise: Higher relative interest rates makes holding a currency more attractive and thus stronger, and lower relative interest rates makes holding a currency less attractive and thus weaker.

Conclusion: From the first conclusion and the additional premise it follows that lower stock prices will make currencies of high interest rate countries such as Australia less attractive and thus lower its value compared to currencies of countries where interest rates were close to zero to begin with, such as Japan.

This explains quite nicely why currencies of countries with high interest rates to begin with, such as the dollars of Australia and New Zealand and the U.K. pound has lost so much in value during the current bear market in stocks while the currencies of low interest rate countries such as Japan and Switzerland has gained in value. And this also explains why the U.S. dollar has stopped falling along with stock markets like it did in 2007 and early 2008, and has instead started to rise against most currencies . In the beginning, the U.S. had fairly high nominal interest rates (5.25%), and when they were reduced the dollar initially lost a lot of value. But once the U.S. had already joined the low interest rate club which previously only included Japan and Switzerland, the additional declines in stock market value would inevitably cause the interest rate differential against other countries to decline, and so strengthen the U.S. dollar.