Stock market indications

While we do not normally think of equity markets containing information on relative currency movements, they in fact are quite useful in this regard. Stock prices discount information on future returns, and in a global market those future returns reflect the currency-adjusted competitiveness of the country in question. In addition, global stock investors have to convert their funds into the local currency to participate in the local stock market. Both of these factors combine to inject a vital element of expected returns on capital into the currency equation.

The relative performance of the U.S. stock market as measured by the Russell 3000 index to the Morgan Stanley Capital International Euro index led movements in the EUR by an average of 22 weeks, or five months, until the end of 2005. We can summarize the observed counterintuitive relationship by saying capital appeared to flow to the stock market with the weakest prospective currency as if both sides of the Atlantic were somehow able to devalue themselves to prosperity. The situation reversed significantly in 2006. The EUR strengthened even as the European equity markets outperformed the U.S. Did something similar occur in Japan?

Not at all; in fact, the lead-lag relationship reverses here. Relative stock market performance between the Russell 3000 and the Nikkei 225 lead movement in the JPY by 20 weeks. In other words, the currency leads the relative stock market performance when it comes to the JPY. A stronger JPY often is the sign of Japanese investors and firms repatriating JPY for whatever reason and parking these funds in the Japanese stock market.