Tuesday, 31 August 2010

Japan's conundrum - a strong yen and a weak Nikkei

There are few trends in the capital markets which are more easily discernible at present than those relating to two key asset classes relating to Japan - the exchange rate of the yen against the dollar, usually quoted as USD/JPY and the Japanese benchmark equity index, the Nikkei 225.

The first chart below shows a weekly view of the Nikkei 225 captured after trading on Tuesday, August 31st when the index suffered a 3.5% decline to take it back to its lowest level since March 2009.

The weekly perspective from the last three years or so reveals several technical weaknesses which are worth noting:

  • The index failed to overcome resistance at the 38% retracement level from the twin highs on the chart around 18,300 seen in H1, 2007 and the twin lows just above the 7000 level seen at the end of 2008 and in Q1, 2009. The 11,400 level is now a key upside threshold for this index as it represents the failure at this key retracement level as well as the 200 week exponential moving average.
  • However from the overall configuration of the chart it would seem that the upper threshold is not on the agenda but rather the lower levels which may need re-testing in view of the clear break of uptrend lines which have been inserted with dashed lines
  • Also pertinent is the drop below the weekly cloud formation with no obvious cloud levels to provide possible support raising the possibility that the 7000 level is now exposed as a potential target area for testing.

To a large extent the fate of the Nikkei is interwoven with the outlook for the yen. The inverse relationship between yen strength and Nikkei weakness is one of the most widely acknowledged examples of strong correlation, albeit an instance of negative correlation. The weekly chart below for USD/JPY, which shows the relationship of the dollar to the yen and thus weakness on the chart (i.e. lower rates) corresponds to yen strength, is yet another example of a market which is decidedly uniform in direction with an unrelenting trend downwards for the dollar against the yen.

What is striking about the chart for USD/JPY, and this underlines the value of using an Ichimoku framework for analysis, is the failure of the dollar to break above the extended cloud formation which occupies most of the right hand side of the chart. At several points, indicated by the arrows, the attempts by the US currency to break out of the persistent downtrend against the yen have failed to penetrate the cloud from below.

In summary I would suggest that since the outlook for the Nikkei 225 is so closely related to the direction of the yen, unless (and until) the USD/JPY chart can show a convincing and decisive break above the cloud patterns, and the yen can begin to retreat, the prospects for further weakness of the Nikkei, perhaps back to the 7000 level, has to be taken seriously.

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