Patterns of financial crisis: USD/JPY, SP500 and Nikkei 
Written by Forex Automaton  
Tuesday, 10 March 2009 16:10  
The "instanteneous" correlation between the ratio of S&P500/ Nikkei225 stock market indexes and USD/JPY has been mostly positive during the crisis. As with GBP/USD visavis FTSE/DJIA, EUR/USD visavis DAX/DJIA, and EUR/USD visavis CAC/DJIA, one common feature is evident: oneday lag correlation "prefers" to have an opposite sign to the "instantaneous" correlation. For the case in hand, with the "instanteneous" correlation mostly positive, the stock index ratio seems to provide a stable leading indicator for USD/JPY suitable in principle to be incorporated into a trading algorithm. With the ratios costructed this way (symmetrically), the null hypothesis would be to expect a negative correlation: the value of dividendgenerating assets such as stocks is negatively correlated with the cost of money, even without stock market bubbles in the picture, but especially when such bubbles are part of the picture. However, if international capital flows are taken into account, one would have to distinguish between lowinterest and highinterest currencies. A scenario is possible where both value of the stock market in country A and the value of the country's currency can be inflated by cheap money originating in country B. Such a capital inflow would boost the correlation between the indexA/indexB and currencyA/currencyB into the positive territory, provided that the effects of B's monetary policy on B's own stock market are negligible (as very well may be under zerointerest rate policy). Japan has been playing the role of just such a source of cheap funding for years. In general, the sign of the correlation remains the same no matter which way the money flows (the way prescribed by the risk aversion theme or the way prescribed by increased risk appetite). Therefore, the sign of the correlation must have more to do with the character of the bilateral economic relationship (balances of trade and capital flows) than the prevailing trading theme of the day. As always on this site (and in contrast with most of the available literature) the emphasis is on correlation values at nonzero time lags, since these, when nonzero in a regular way, indicate technical predictability of the markets  at least in principle. As before, I work with logarithmic returns, therefore it's irrelevant in what units the quantities are expressed (that is how these indexes are defined and what absolute magnitude they typically assume).
The time evolution of both time series under study, USD/JPY and S&P500/Nikkei225, is show in Fig.1. As before, I define the visible phase of the present financial crisis to begin on August 16, 2007, the day of Countrywide Financial nearbankruptcy event, followed by an extraordinary halfpercent Fed discount rate cut next day. This study covers 82 weeks from August 2, 2007 through February 26, 2009. Fig.2 shows the time evolution of the correlation peak by plotting the correlation values for the negative and positive lags in separate panels.
Overall for the period, looking at same day (zero timelag) data, S&P500/Nikkei225 is seen to be positively correlated with USD/JPY, just like DAX/DJIA and CAC/DJIA are positively correlated with EUR/USD, and unlike FTSE/DJIA and GBP/USD. The time lag is defined as t_{d} = t_{1}  t_{2}, where index "1" denotes USD/JPY and index "2" denotes S&P500/Nikkei225. Therefore, negative correlation values at negative lags (Fig.2, top panel) mean that movements of the opposite direction in USD/JPY and S&P500/Nikkei happen at an earlier time in forex, or USD/JPY is a leading indicator for Nikkei/S&P500. For the forex trader, the bottom panel of Fig.2 is more interesting as it deals with potential leading indicator for USD/JPY. Negative correlation values at positive lags mean that movements of the opposite direction in USD/JPY and S&P500/Nikkei happen at an earlier time in the stock markets, or S&P500/Nikkei is a leading indicator for JPY/USD. Speaking of stable patterns, clearly the tendency for the 1day lag correlation value to be of an opposite sign to the "instantaneous" (lag zero) correlation value is seen here just as it was seen in many similar studies mentioned above.


Last Updated ( Monday, 04 January 2010 12:39 ) 