The Euro/Yen Cross Rate
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Since its creation in 1999, the movements of the euro currency versus the dollar have shown an increasingly positive correlation to the movements of the U.S. stock market. Exactly why it works this way is interesting to ponder but not particularly relevant for analysis. The fact of the correlation carries more importance than any reasons why it should or should not work that way.
For doing comparisons of the euro to the SP500, I like to go one step farther, and look at the euro/yen cross rate. This is the exchange rate which would apply if you wanted to exchange some of your euros for Japanese yen, or vice versa. Doing this seems to produce an even better correlation, as it incorporates the yen's recent role as the beneficiary of the so-called "risk off" trade in addition to the euro's role as "risk on" target.
The fun part of this relationship does not lie in the finding that there is a good correlation most of the time. Instead, the real utility comes when we see a disagreement between the euro/yen cross rate and the SP500. When divergences appear, it is usually the euro/yen cross rate that knows the true story about where both are headed.
Just recently, we saw a peak in the euro/yen cross rate back on Feb. 5, and it has now broken its 3-month rising bottoms line which is a pretty clear indication of trend change. But the SP500 had carried on for a while as if nothing was wrong, and only recently started running into some turbulence.
That divergence, with the euro/yen cross making a lower high and the SP500 making a higher high, was a big sign of the trouble that is just now coming around to the stock market. And even though the SP500 was knocked down pretty hard in February, it appears to be trying to get back up off the mat.
The euro/yen cross rate does not offer any hope that the SP500's recovery effort will be successful. The stock market might still ignore that message, as there is no guarantee that the euro/yen cross rate has to be "right" this time. But there is considerable historical evidence that when they disagree, it is more often the euro/yen cross rate that knows the real story.
Editor, The McClellan Market Report
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