HEARD ON THE STREET: Japanese Stocks Still at Yen's Mercy

Another day, another sickening decline for the Nikkei. Japan's benchmark stock index fell 6.4% Thursday, and has now lost more than 20% since peaking on May 22.

In recent days, a rebounding yen has supplanted volatile interest rates as the main drag on Japanese equities. The fact that Japan's stock market remains principally a play on a weakening currency reveals that the country has failed to convince the world it can revive its domestic growth engines.

The initial trigger for the ongoing correction in Japanese stocks was a rise in the country's government bond yields. But the yield on 10-year JGBs, which briefly spiked above 1% on May 23, has stabilized at around 0.85%.

The surprising strength of the yen has since emerged as the bigger culprit. A dollar bought just over 94 yen late Thursday, down from 96.08 overnight in New York and 98.8 late Monday.

Japan's currency and its stock market have long had a tight inverse relationship, as a weaker yen means higher earnings for Japanese exporters. The yen fell nearly 23% against the dollar from the start of November to late May, as a new government came into power and set off massive monetary easing by the Bank of Japan. The yen's slide corresponded with a massive 75% rally for the Nikkei over the same period. Now that trade is unraveling.

A combination of factors has contributed to the yen's sharp rise. First, markets are unnerved by the prospect that the U.S. Federal Reserve will soon start exiting its quantitative easing program. That is causing flows into yen, which still retains its status as a "safe haven" currency that traders flock to in times of uncertainty. And second, the Bank of Japan disappointed yen bears after its monthly meeting on Tuesday by failing to add to its easing plans.

The level of the currency on any given day might not matter so much if Japan were less dependent on exports for growth. But a package of structural reforms meant to unleash the domestic economy fell flat when unveiled last week as it failed to tackle the issues like labor market rigidities and negligible immigration that are holding back growth. Until the Japanese government summons the political courage to make painful but necessary reforms, the country's stock market will be held hostage to the yen exchange rate.