WHY EURO IS MORE CLOSELY CORRELATED WITH DOLLAR INDEX THAN THE YEN -- YEN CONTINUES TO WEAKEN AGAINST DOLLAR AND EURO -- TRENDS IN FOREIGN CURRENCIES IMPACT RELATIVE PERFORMANCE OF THEIR STOCK ETFS
WHY YEN AND USD SOMETIMES DROP TOGETHER ... Normally when I discuss the direction of the U.S. Dollar, I use the U.S. Dollar Index (USD). The USD measures the dollar against six foreign currecies. In my view, it gives a truer picture of dollar trends. Following my dollar article on Tuesday, one of our readers asked why the USD and the Japanese yen sometimes trend in opposite directions and sometimes in the same direction. It's a timely question given recent trends in the yen, and concerns both in the U.S. and Europe that it's too low. I'd also like to expand on the idea of how the direction of a foreign currency (like the yen) impacts on a foreign ETF (like Japanese iShares). But first a brief explanation of the composition of the U.S. Dollar Index and why some currencies influence it more than others. The green line in Chart 1 is the US Dollar Index since its 2002 peak. The blue line is the Euro. Notice the very close inverse correlation between the USD and the Euro. The orange line is the Japanese yen. The inverse link between the USD and the yen isn't as strong. Part of the reason has to do with the weighting of the currencies.
Chart 1
THE EURO HAS STRONGEST LINK TO THE DOLLAR ... Of the six foreign currencies measured against USD, the Euro represents more than half of the foreign basket (57%). The next biggest is the yen (13%). As a result, the Euro has by far the biggest influence on the USD. From the start of 2002 to the start of 2005, the Euro and yen both rose while the USD fell. Over the last two years, notice that the yen has been much weaker than the Euro. Some of that discrepancy between the two currencies is tied to Japanese attempts to keep the yen from rising too fast (which has led to recent complaints from the US and Europeans about that practise favoring Asian exports). A lot of it also has to do with interest rate differentials between the two regions. European rates have been rising much faster than Japanese rates and are likely to continue doing so. As a result, the Euro is approaching a record high against the yen. Chart 2 plots a ratio of the Euro divided by the yen. Notice the big jump in the ratio since 2005 when the two currencies started to diverge. [Relative weakness in the yen isn't limited to the Euro. Since the start of 2002, the USD has lost 30%. The Euro has gained 51%, the British Pound 40%, the Swiss Franc 38% and the Canadian Dollar 34%. The yen gained only 11%].
Chart 2
THE USD AND YEN CAN FALL TOGETHER ... Chart 3 shows the Japanese yen (orange line) and the U.S. Dollar Index (green line) both losing ground since the middle of 2006. The reason that can happen is because the USD measures the dollar against a basket of foreign currencies. While the yen is falling primarily because of its own low interest rate environment, the USD is being pushed lower by rising European currencies. Now let's address the impact the weak yen has on Japanese iShares.
Chart 3
IMPACT OF YEN ON JAPANESE ISHARES ... The direction of a foreign currency (relative to the dollar) has an impact on the relative performance of that country's stock market Exchange Traded Fund. Chart 4 compares the Nikkei 225 (black line) to the Japanese iShares (orange line) over the last ten years. Sometimes the EWJ rises faster than the Nikkei, and sometimes it rises slower. The blue line below the prices in Chart 4 is a ratio of the Japanese iShares (EWJ) divided by the Nikkei. The EWJ:Nikkei ratio rose from 1998 to 2000 and again from the start of 2002 until the start of 2005. The ratio has been falling for two years. The reason is the falling yen. The bottom green line in Chart 4 is the Japanese yen. Both lines trend in the same direction. Chart 5 gives a closer comparison of those two lines. The black line in Chart 5 is the EWJ:Nikkei ratio. The orange line is the yen. They clearly rise and fall together. The reason is simple. While the EWJ is quoted in U.S. Dollars (as are all ETFs), the Nikkei is quoted in yen. When the yen is strong, the EWJ acts better than the Nikkei. When the yen is weak (which has been the case recently), the EWJ underperforms the Nikkei. [That also explains why a weaker dollar boosts the value of foreign stock market ETFs relative to their respective stock markets].
Chart 4
Chart 5
STRONG BRITISH POUNT BOOSTS UK ISHARES ... While a weaker yen has hurt the relative performance of Japanese iShares, a strong British Pound is having the opposite effect on UK ishares. The black line is Chart 6 is a ratio of UK iShares (EWU) divided by the FTSE for the last two years. The blue line is the British Pound. Once again, the two lines trend in the same direction. In this case, however, the rising Pound has caused UK iShares to rise faster than the actual British stock market.
Chart 6
BOUNCE IN EURO BOOSTS GOLD -- FALLING YEN HURTS EWJ ... In today's currency trading, the Euro rose on an ECB statement hinting at higher European rates in March, while the yen fell on a BOJ official warning that a Japanese rate hike is further in the distance. Because of its heavier weight, the rise in the Euro is having a bigger influence on the Dollar index than the drop in the yen. As a result, the Dollar Index is falling and commodity prices are rising. The Reuters/Jefferies CRB Index is up nearly five points. Gold has risen $7.00 and crude oil is up nearly $2. The drop in the yen helped push Japanese iShares (EWJ) down 1.30%making it the day's weakest foreign stock market ETF.
Chart 7
Chart 8
