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Are the Nikkei and the yen divorcing?

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Koichi Kamoshida | Getty Images

The long-standing inverse correlation between the yen and Japanese stock prices has broken down, suggesting the Nikkei could rise even if the Japanese currency doesn't weaken further, analysts say.

"The rise in the Nikkei and its decoupling from a weaker yen is driven not by fundamentals but depends on the flow of money from pension funds," said UBS Japan equity strategist Tomohiro Okazawa. "The relationship between the Japanese stock market and the U.S. dollar/Japanese yen (pair) has been strange since mid-February."

The Nikkei rose 7 percent in February to a fifteen-year high even though yen only weakened by 1.4 percent against the dollar.

Seismic wave of public money

The inverse correlation between the yen and Japanese stock prices has held since 2006, according to UBS's Okazawa.

The correlation's strength was evident over the past few years: since Prime Minister Shinzo Abe returned to power in December 2012, triggering a stock rally with his promise to return Japan to economic growth, the Nikkei has risen over 100 percent, while the yen weakened by 45 percent.

But a wave of public money appears to be upending that trend after Japan's Government Pension Investment Fund (GPIF) raised its stock holding allocation to 25 percent from 8 percent in October.

A one percentage point shift by the GPIF into stocks is widely seen as worth around 1 trillion yen ($8.35 billion), and has driven the Nikkei's rally, according to analysts.

With other semi-public pension funds gearing up to benchmark their allocation ratios to GPIF's, Okazawa says stocks could be headed upwards for a while yet, regardless of how the dollar-yen moves. Last week, public employee pension fund KKR said it would mirror GPIF's new allocation policy. If others follow, they could pump several hundred billion dollars into Japan stocks, he said.

More upside, but risks abound

Other factors also point to further upside.

"Japan Inc will undertake more corporate actions, dividend increases and buy backs, in line with Abe's push to reform corporate governance," said Parry International Trading managing director Gavin Parry.

Is the Nikkei rally unstoppable?

"The fact that this inverse correlation broke down, with the yen relatively firmer but the Nikkei still adding gains, gave us a strong indication of underlying bullishness" on Japanese corporate earnings and stocks, he added.

But a Federal Reserve rate hike later this year could restore Japan's inverse stock-currency correlation, limiting gains, analysts warn.

"Last time the Federal Reserve raised interest rates in 2005, the [dollar-yen pair] rapidly lost 10 yen. While we don't think the yen would be as vulnerable this time, the [pair] could still gain several yen and drive down Tokyo stocks," he said.

Many analysts expect the Federal Reserve to start hiking rates around mid-year.

Okazaki sees the Nikkei ending the year at around 19,000, but does not rule out the possibility of the index flirting with the 20,000 level towards year-end.