Japan’s stock market has been red hot in recent months, with the Nikkei 225 index soaring past its 1989 peak. However, as history often reminds us, what goes up must come down.
One factor that could be a harbinger of a potential decline is the strengthening of the Japanese yen, catalyzed by the Bank of Japan’s shift toward a tighter monetary policy in the face of inflationary pressures.
Usually, a strong currency paints a picture of a strong economy, but the relationship between the yen and the Nikkei 225 is historically inverse.
What Is Going on with the Yen?
A stronger yen makes Japan’s export-driven economy less competitive on the global stage, which impacts corporate earnings. In turn, corporate earnings influence stock prices. The yen’s strength, particularly against the U.S. dollar, has been associated with the Nikkei’s periods of underperformance.
When we look at the yen now, it looks like a major turn could just be starting.
For years, the BoJ has maintained an ultra-loose monetary policy. Negative interest rates have been a cornerstone of its deflation-combating strategy. However, with inflationary trends emerging, a policy reversal is on the horizon. This shift could see an end to negative interest rates and a tightening of monetary policy, which traditionally results in currency appreciation. This could have all kinds of implications on global currencies, such as sparking volatility.
Now to be fair, the Nikkei’s extraordinary performance has been buoyed by Japan’s strong earnings, attributable to broader corporate reform that has helped make companies more efficient.
But the biggest driver of these strong earnings has been the yen. A reversal in currency trends could lead to downward revisions in earnings forecasts and, by extension, stock valuations. This is particularly pertinent as export giants like automobile and electronics manufacturers form a significant portion of the Nikkei.
The Bottom Line: Brace for a Global Crash
The global economic context can’t be ignored. With other central banks, notably the Federal Reserve, indicating a move toward rate cuts, the contrast with Japan’s tightening could exacerbate the yen’s rally. Historical precedents, such as the market’s response to the Plaza Accord in 1985, which led to a significant appreciation of the yen, resulted in a short-term decline in the Nikkei.
While the Japanese market has several structural tailwinds, the historical data suggests that the current heights of the Nikkei may not be sustainable under a strengthening yen.
As the Bank of Japan navigates away from its long-standing strategies, the market may have to brace for impact. Prudent investors should keep a keen eye on the BoJ’s policy direction and the yen’s trajectory, as these could be critical in determining the Nikkei’s fate in the coming months. And by extension, perhaps all risk assets.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
