Sharp falls in Japanese equities have started to strengthen the yen as foreign investors unwind hedges they took out to protect themselves from the yen's recent slide, leaving currency traders hanging onto every move in the Nikkei share index.
While the correlation between the Japanese benchmark and the dollar/yen was easy to understand when stocks were skyrocketing, their tandem skydive over the past two weeks has left puzzled traders in London scrambling for answers on how to handle the Nikkei futures market.
"Equity investors would tell you that stocks are falling because the yen is stronger, but currency traders know that the dollar-yen is tracking the Nikkei's movements... hedging is a big factor," said Kenichi Asada, manager of forex at Trust & Custody Services Bank in Tokyo.
A weaker yen on the back of aggressive easing from the Bank of Japan sparked a flood of money into Japanese equities in recent months on expectations that exporters' overseas revenues would benefit. The Nikkei surged by some 80 percent between November and late May.
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But when foreign investors bought Japanese equities they had to hedge the investment by buying dollars against the yen.
Without doing so, their year-to-date net gain on the Nikkei - still up 25 percent in local currency terms - would have only been 10 percent, lower than that for the S&P 500.
Foreign investors had to continue buying dollars as the Nikkei climbed to maintain a hedge ratio of around 20 percent, according to Nomura analysts, who say that helped yen selling reach an estimated 1 trillion yen ($10 billion) in the week ended May 19.
But a precipitous fall in the Nikkei over the past two weeks has forced overseas investors to do the reverse. The dollar-yen is now locked in step with the stock market, with the yen strengthening every time the Nikkei falters, and vice versa.
Nikkei Says Jump, Yen Traders Ask How High
The Nikkei's 7.3 percent plunge on May 23 plucked the yen off a 4-1/2-year low of 103.74 plumbed in the previous session, and its subsequent losses have brought the yen nearly 4 percent off that trough.
Against the yen, the dollar has gone in the same direction as the Japanese benchmark during Tokyo trading hours for eight sessions of the last 10.
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On Wednesday, a sudden 1.6 percent spike in Nikkei futures coaxed the Nikkei up 1 percent before it slumped 3.8 percent by the close. The dollar/yen followed suit, tacking on 0.3 percent before dropping 0.5 percent by the stock market close.
Jolts in Nikkei futures in afterhours trading have also prompted some whippy currency moves in both directions.
On May 30, a Reuters report that the Japanese government was to urge the nation's public pension funds to increase their investments in equities prompted a 1.6 jump in Nikkei futures, which in turn spurred a 0.5 jump in the dollar against the yen.
"The rationale behind the yen selling on the back of Japan's GPIF headlines seems linked to the hedging behavior of foreign investors buying Japanese stocks," said Valentin Marinov, head of European G10 FX strategy at Citi in London at the time.
However, given the opacity of hedging trades, some market participants see the effect as more psychological.
"It's kind of suspicious as you usually can't see the effect of hedges being made on the swaps market," said one trader at a major Japanese bank in Tokyo.
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"What's happened is that a lot of people believed the logic in unwinding hedges as stocks fall. The more people start focusing on the pattern the more the spot market has to chase it."
The relationship is expected therefore to break down at some point as it is shouldered out by other trading factors, such as whether the U.S. Federal Reserve will start tapering its easing programme early, which would likely see a spike in Treasury yields.
"The danger is that people start looking for correlations and the correlations start reinforcing themselves, then they break down because the fundamentals don't justify them," Elsa Lignos, currency strategist at RBC in London.
But for now, investors ignore the mirror between the yen and the Nikkei at their own peril.