Tuesday, January 20, 2009

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.


Blogger Celal Birader said...

The Swiss Franc has been in decline ever since Dec 29 and declined by over 2% just today. Perhaps this is because the CHF is more closely correlated to the movement of the EUR which it has been closely following during this time.

1:21 AM  
Blogger stefankarlsson said...

As I wrote, the correlation is not perfect (almost no causal relationship has a perfect empirical correlation) as there are other factors which affect exchange rates.

But if you're talking about the CHF/USD exchange rate than that is of little relevance for this discussion as the USD is essentially the same as the CHF from this perspective.If you look at the more interesting CHF/EUR you can see that the CHF depreciated during the week to January 6 when stock markets rallied and has since appreciated during a time of sell-offs.

8:16 AM  
Blogger CV said...

Hi Stefan,

Thanks for the plug.

Interesting points on the causality too. Clearly, now that a lot of central banks are headed for the zero bound (if not all of them eventually) it will be interesting to see just where the "carry" will be. Obviously, if the US becomes a funding source of the carry trade (which it may or may not be already) then we could see some quite frothy asset markets in key emerging economies at some point.

As for the correlation there are two issues I think. Causality (which is well damn near impossible to verify) and stability of the relationship. Clearly, it is very dangerous to punt on this correlation since if and when it turns it completely changes direction. I.e. as we saw with the USD.JPY. The backlash for any carry trade basket portfolio is devastating. So, while the relationship is strong when averaged over a long time a sudden deviation from the correlation usually comes in the form of a sharp reversal.

As for regression analysis you have an even more delicate issue in terms of causality, but as I have also shown, a traditional CAPM technology yields the same result as the correlation analysis.


4:16 PM  
Blogger Jeremy Goodridge said...

Stefan: A clarification question:

How come low interest rates in a country make its currency more attractive? Or is it the fact that the interest rates have reached bottom that make its currency more attractive? And if so, why is that -- why would investors want to buy the currencies of a country whose interest rates are at zero?

thanks a lot!

10:20 PM  
Blogger stefankarlsson said...

Claus: I'm not sure I understand your point, but a point I made was that you can't rely on any currency being necessarily the same in response to stock market moverments and so interest rate movements. And so, any portfolio strategy must update that composition. Witness for example how the USD went from reacting negatively to reacting positively to stock market sell-offs.

As for establishing causality, that can't be done in an econometric way, it must be done in a praxeological way (see the original post for an example of this).

Jeremy: It's not that zero interest rates make a currency more attractive. it's that it can't from that perspective get any more unattractive (since interest rates can't fall below zero) and that so in an environment where interest rates are generally falling, it will become more relatively attractive.

As for why they would want to buy them, you're looking at it the wrong way. And by that I mean that people in the past might have weighed on owning the zero interest currencies for various reasons, but might have been persuaded by the interest rate differential not to. But once the interest rate differential diminishes, the other reasons become more relevant.

The other reasons might have BTW for example included domestic savers not wanting to take the exchange rate risk, or foreign central banks wishing to hold down the value of their currencies for mercantilist reasons.

11:50 PM  
Blogger Celal Birader said...

On a related matter, i read today on Bloomberg that Japan's December 2008 exports are down 35% over December 2007. The question is : Why isn't the BOJ doing anything about the high value of the Yen to help it's exports ? I understand it can't go lower than zero on interest rate policy but surely it could move the exchange rate lower by simply printing more Yen, could it not ? So why is it not doing this ?

9:05 AM  

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