Traders are always on the lookout for patterns and indicators that can help them predict future stock market returns. The one we are going to present to you today involves the economic relationship between stocks and currencies: is EUR/JPY a leading indicator for stocks?
Due to investor psychology, EUR/JPY is often considered a leading indicator for stock market movements. There is a heightened desire for Euros to invest in stocks during good times, whereas, during challenging times, the inclination shifts towards seeking Yens as a safe-haven strategy.
In this article, we are going to explore why EUR/JPY might be a leading indicator for stocks and backtest some trading strategies to test this hypothesis.
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Why would the EUR/JPY be a leading indicator for stocks?
There is a popular belief that EUR/JPY is highly correlated with stocks, especially European stocks. The basic idea behind it is that whenever the CAC 40, for example, rises, we can probably expect the euro to rise as well, as investors need to get a hand on some euros to buy stocks.
However, whenever the economic situation worsens, or traders are fearful, we usually see investors take their money out of the stock markets, which causes the CAC 40 to drop in value.
Because the Yen is considered to be a safe haven amongst the major currencies, investors sell the Euro and “hide” in the Yen. As a result, EUR/JPY falls.
The idea makes sense, but that is not enough to say it works. Here is the 1-year rolling correlation between a European ETF (VGK) and EUR/JPY:
As you can see, the mean is slightly positive, but the highest correlation was during the financial crisis. In the past few years, the correlation has not been strong. But in order to see if this theory really works, we need to backtest some trading strategies.
Is EUR/JPY A Leading Indicator For Stocks? – trading rules
The trading strategy we are going to backtest is pretty simple:
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Is EUR/JPY A Leading Indicator For Stocks? Backtest
We backtest the strategy for German, French, and Italian stocks using the ETFs with the following ticker codes: EWG, EWQ, and EWI. The data is adjusted for dividends (reinvested). Here is the equity curve for German stocks (EWG):
The returns look very good! Here are some metrics and performance statistics:
- CAGR is 6.73% (buy and hold 7.2%)
- Time spent in the market is 42.3%
- Risk-adjusted return 15.91% (CAGR divided by time spent in the market)
- Maximum drawdown is -35.46% (-63.1%)
Here is how the same strategy would have performed for French stocks (EWQ):
And lastly here is Italian stocks (EWI):
We won’t show you the performance metrics of the last two ETFs, but by looking at the graph, you can guess pretty well how they do. In all three countries, the returns are practically the same as buy and hold, but you are invested only around half the time. More importantly, maximum drawdown is also significantly reduced, making this strategy even better.
Is EUR/JPY A Leading Indicator For Stocks? – Conclusion
To sum up, the strategy seems to work pretty well. The idea that the EUR/JPY relationship can be a leading indicator for stocks is correct according to our backtests. However, we wouldn’t rely solely on this indicator to trade stocks. Pairing it with another technical indicator or into a trading system can work better than on its own.