When traders want to know which way stocks are headed, they look to the Japanese yen.
Top strategists on Wall Street say the yen is set to weaken a lot further this year, and that should be a bullish sign for stocks, even with the S&P at record heights.
The dollar currently is trading at 102 versus the yen. Jens Nordvig of Nomura expects the rate to climb to 110 versus the yen in the second quarter and to 114 by year-end.
Alan Ruskin at Deutsche Bank forecasts 115 by the end of 2014. Steven Englander of Citigroup predicts 107 but said, “I think the risk is very heavily concentrated to the upside”—meaning a weak yen is set to weaken further.
The relationship is very much intact: When the yen weakens, the U.S. stock market tends to rise, and when it strengthens, equities fall. Why?
The yen has always been a key sentiment barometer, a read on the mood of global markets because of the carry trade: when traders use yen to fund cheaply (because of its low rates) and buy riskier, higher-yielding currencies such as the Australian dollar. When Aussie-Yen gets bought (Aussie strengthening against the yen), the movement in risk assets—including global equities—follows.
(Read more: Panic over; buy EM currencies: HSBC)
What’s new is that Abenomics has supercharged the traditional carry trade. Part of Prime Minister Shinzo Abe’s plan is to inflate the economy and assets by massive quantitative easing, or bond-buying. The central bank is buying $78 billion a month and doubling the monetary base—more powerful QE than the Fed’s because Japan’s economy is smaller.
And what’s even newer is the Fed’s tapering, or scaling back, its QE, making Japan the center of the liquidity action. And the dollar-yen more of a carry candidate (Fed pulls back as BOJ ramps up).
Investors are using the yen to borrow cheaply in yen, sell it and buy the dollar, to purchase riskier assets such as U.S. stocks. The U.S. is considered a top destination for risky trades right now, with the nation in recovery mode, corporate earnings generally beating on the bottom line, and calmer politics and more stable economic conditions.
So the carry trade, which the Bank of Japan is supporting heartily, is helping money find its way to U.S. stocks.
What’s more, when macro themes are driving markets—fading risk of a meltdown in emerging markets, better Chinese data, Europe in recovery—correlations tend to increase.
There’s another factor.
A weak yen props up the Nikkei, and U.S. stocks have been closely tracking Japanese stocks lately.
It is also a blessing for Japan’s exporters, because it makes their televisions and cars and electronics more competitive globally. That move has been fueling the Nikkei, helping it surge 57 percent last year.
This is a year of transition. The major central banks have been flooding the market with liquidity and crushed volatility since the crisis. Now that we’re moving away from unconventional policy, the volatility could pick up.
—By CNBC’s Sara Eisen