When equities and USD/JPY are moving in different directions, we like to look at the commodity and Treasury markets for more clarity on investor sentiment. Interestingly enough, gold prices have fallen today while bond yields have risen, which is in line with stronger risk appetite and the rally in USD/JPY. As for why the decoupling is a happening, we turn to volatilities.

The volatility in USD/JPY has fallen to the lowest level since October. As “risky assets,” the yen crosses and other high yielding currency pairs are sensitive to the level of volatility in the foreign exchange market. Carry trades tend to sell off in environments of high volatility and rise in environments of low volatility. This inverse correlation is illustrated in the following chart. The white line represents the volatility of 3 month at the money USD/JPY options while the green line is the price of USD/JPY.

The decline in volatility is helping to boost the market’s appetite risk and restore demand for higher yielding currencies. Also, investors may finally be responding to the weakness of Japanese economic data and the new measures announced by the Bank of Japan last night. If volatilities stabilize, then we may see USD/JPY and US equities move in lockstep once again.

Why the Dow Could Be Headed Lower

I read this fascinating study by Barclays Bank this morning on how the performance of the Dow in the month of January can set the tone for trading throughout the year. In the first month of 2009, the Dow Jones Industrial Average fell 12 percent. According to Barclay’s study, if there is negative equity market performance in the month of January, the odds of stocks ending the year low rises from 32 to 69 percent. This is based upon 74 years worth of data. Since currencies are taking their cue from equities, further weakness in the Dow could mean further strength for the low yielding US dollar and Japanese yen.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.