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Trouble for the US Equity Market? Recent Weakness in Nikkei Index Points to 'Yes'


The Japanese index has already experienced what Wall Street calls the "Death Cross" -- US equities may feel it next.

Although Japan has undergone unprecedented stimulus measures over the past year, events across the globe have led investors to park funds in the safe-haven yen. Pro-Russian protesters overtook a government office in the Ukrainian city of Donetsk on Thursday. The group threw stones and smashed windows, accusing the office of working for the Western-backed government in Kiev. The uprising is just one of many made by Russian separatists in Ukraine over the last few weeks, creating volatility within emerging market economies in the region.

Along with geopolitical risks, Federal Reserve policy continues to promote US dollar outflows. The Fed said on Wednesday that it was looking past dismal first-quarter growth due to weather in the hopes the economy picks up during the spring months. This led policymakers to favor cutting its bond-purchases program by another $10 billion, making the monthly purchases total only $45 billion now.

Although it may seem as if cutting bond purchases again in April is a hawkish move by the Fed, the market has priced in this event for many months. The only way the market would have been surprised on Wednesday was if the Fed either chose not to cut stimulus or cut stimulus by more than $10 billion. The fact that the Fed acted as expected means that investors continue to believe US benchmark rates will stay low till the middle of 2015.

The geopolitical risks in Russia and steady US monetary policy are leading investors to move funds into the yen. This in turn has led the Japanese Nikkei 225 (INDEXNIKKEI:NI225) equity index lower throughout 2014. In the chart below, you can see that the 50-day moving average has crossed the 200-day moving average for the Nikkei, creating what Wall Street likes to call the "Death Cross."

Click to enlarge

The yen and Nikkei have a notorious relationship of being strongly negatively correlated. When the yen weakens, it's viewed as bullish for Japanese equities, and vice versa. This is due to the Japanese economy being very export-dependent, meaning a weaker currency makes export prices lower and thus more in demand. Part of the Nikkei's decline has been result of a stronger yen based off of the global events listed above. The relationship between the US dollar and US equity market is less negatively correlated, which could be a reason why US equities have yet to experience a similar "Death Cross" like the Japanese index.

Although global market volatility has pushed investors into the relatively safe Guggenheim CurrencyShares Japanese Yen Trust (NYSEARCA:FXY), the index hasn't reached new highs over the past three months. On the chart below, it's apparent that the yen is in a range-bound state, most likely due to the reluctance of US equities to decline as much as the Nikkei index.

Click to enlarge

Investors have, however, noticed the Nikkei's weakness, and it's weighing on sentiment. Global equity markets, especially those in the developed world, tend to correlate strongly positive. If US equities finally do crack, it could deal a further blow to Japanese equities. Similarly, if the yen breaks higher for whatever reason, that, too, could be enough of a catalyst to bring US equities off of near-record highs.

Andrew Sachais' focus is on analyzing markets with global macro-based strategies. He takes into consideration global equity, commodity, currency, and debt markets. Sachais is a graduate of Georgetown University, where he earned a degree in Economics.

Follow Andrew on Twitter: @MacroInsights
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