Evan Soltas
Mar 1, 2015

From Japan to Switzerland

How do big shocks to the exchange rate affect stock prices? We can look at two recent examples: the devaluation of the Japanese yen under the Kuroda regime shift and Jordan's de-pegging of the Swiss franc.

As the Japanese yen has dropped, the Nikkei has soared. That's not just a story of two broadly matching trends, either. The relationship holds strongly on a day-to-day basis, suggesting that whatever's driving the yen down is also driving the Nikkei up.

I think the first thing to ask with Japan is: Has it always been this way? To retell the conventional story, Japan has struggled with persistent deflationary pressures and a rising yen. Maybe it's the case, then, that whenever markets saw the yen weakening, they also became excited about the prospects of Japanese companies, particularly exporters?

Or we could tell a similar story that says this really isn't about exporters gaining from a weak yen to undercut competitors in foreign markets and pocket some profits. Pretend, for a moment, that all Japanese companies did was export and price goods in the local (i.e. export-destination) currency, and they didn't increase production or profit margins or gain market share. Then if the yen depreciated, and input prices didn't change, we should expect profits to rise passively one-for-one in yen, but stay flat in other currencies. What's merely going on is that when the Japanese exporters repatriate foreign profits, they will do so into a devalued currency.

But wait, there's more. The Bank of Japan's regime change has set off a wave of capital flows, both into and out of Japan as well as within Japan and among Japanese asset classes. For example, Japanese retirees sitting on portfolios of government bonds have seen yields come crashing down, and they have responded with some combination of pouring into Japanese equities and getting their money out of yen-denominated assets.

The first two stories seem to require the relationship between the yen and the Nikkei to be an "always-and-everywhere" thing. That is, it's not clear why a cheap yen would only sometimes help exporters, and not other times. Similarly, the passive repatriation story should always hold. But the third story is really about a third cause, a single event, behind these two patterns.

So let's take this to the data.

It turns out that the link began in 2007 -- a time when things were going the other way, that is, the Nikkei was falling on the days the yen was appreciating. There doesn't ever seem to be much of a sustained pattern before then, but maybe somebody who knows Japan better than I do can make something intelligent out of the squiggles of the 1980s and 1990s.

I think this puts a lot of doubt into the first and second stories, which is surprising to me, because both make a lot of sense! It's quite believable the Japanese yen is really just the repatriation currency for countries that do business elsewhere or that Japanese exporters benefit from a weak yen, although admittedly input prices is a bit of a problem for that story.

We should also take a look at the value of the coefficient: It's around, maybe a bit less than, one. That might actually work with the repatriation story. But hold on a second. If you look at the cumulative change in the yen and in the Nikkei, what you get is a 2-for-1 relationship. That is, for every one percent decline in the value of the yen against the U.S. dollar, Japanese equities rise 2 percent. And that would require more than the repatriation effect.

So my read of the Japan situation is that the relationship between the yen and the Nikkei is a historically contingent one that has emerged from two big waves of capital flows, the 2008 risk-off amid the financial crisis and then the 2012 Kuroda shift. The other stories don't fit the data.

Now onto Switzerland. On January 15, the Swiss central bank suddenly announced it would stop defending a currency floor that kept the Swiss franc from appreciating beyond 1.20 franc to the euro. The basic reason, the data suggest, is that it did not want to keep expanding its balance sheet. That day the Swiss franc appreciated nearly 20 percent against the euro.

What happened to stocks? As this chart from Markus Brunnermeier shows, they fell a bit less than the currency rose:

Brunnermeier focuses here on the Swiss financial sector, which handled the Swiss franc's sudden rise about as well as the broader economy. We might also break out companies in the index that are particularly focused on foreign markets, such as Swatch, Credit Suisse, Nestlé, Roche, and Novartis. They also seem to have dropped somewhat less than the rise in the Swiss franc. In fact, if you look at a currency-hedged index of Swiss equities, that rose sharply on the day of the de-pegging.

The advantage of Switzerland as a case study is that the appreciation was unanticipated, whereas in Japan, the whole point was to shout it from the rooftops. This shuts off the capital-flows story and leaves us with the two export-oriented ones. It doesn't seem likely the Swiss exporters were very much disadvantaged -- despite their complaints -- if Swiss equities rose when converted to other, more stable currencies. What it fits, rather, is the passive repatriation story: Swiss exporters' profits fall in Swiss franc when the franc rises because every dollar of foreign profits is worth less in Swiss franc than it was before. Another reason why it might not be surprising that Switzerland seems to fit that story: Switzerland is a vastly more export-heavy economy than Japan. Its exports-to-GDP ratio was 72 percent in 2013, as compared to Japan, which stood at 16.2 percent of GDP in 2013.

While Japan and Switzerland both fit the same pattern -- currency up, stocks down; currency down, stocks up -- the patterns emerged for distinct reasons. For Japan, it was the coordination of capital flows, whereas for Switzerland, the explanation seems to be that exporters would have to repatriate profits at a punishingly high exchange rate.