Chinese shares coming back just in time … for another fall.

We always watch inter-market correlations. We believe it helps determine capital flows which helps with timing investments and trades. A popular one is the correlation between the Japanese yen and the Nikkei. Historically they share a tightly negative correlation – when the yen appreciates, the Nikkei loses value; and vice versa. Japanese investors’ appetite for risk is a large driver of this correlation. The correlation became a little loose in November/December 2010, but you can see it has come back together – the Nikkei has jumped to new highs in February while the yen has fallen back fairly sharply through key support.

JPYUSD (black) vs. Nikkei (orange):

The Bank of Japan and government officials have been on the wires recently about sounding a more optimistic tone on the Japanese economy. And in the wake of positive growth data out of the US and some other larger economies, this together may help the Nikkei may find some support from investors.

The story may be a little different for China, where expectations are a complete 180-degree difference from those in Japan. Despite a general “risk-on” appetite for global financial markets over the last few months – S&P 500 stronger, commodities stronger, currencies stronger versus the US dollar – Chinese share have taken the brunt of Chinese tightening expectations. Oddly, this risk has not seeped into global risk appetite.

Indeed, we noticed from watching our inter-market correlations that the Shanghai composite had been seriously underperforming. But in the last 2-3 weeks this measure has come back in line with the general mood.

For example, we consider any correlation of greater than 70% or less than -70% as being rather high. The Chinese market being closed for the Chinese New Year impacts short-term correlations a bit, but over the last 34 days the only asset we track that maintained a tight correlation with the Shanghai composite was gold. That is, gold and the Shanghai composite moved together (73%). It just so happened that over much of that time gold was moving lower as its safe-haven appeal faded and other commodities received inflation-driven investment flows.

But in the last two weeks the Shanghai composite has fought back. It has been driven by a rebound (perhaps a dead cat bounce) in property and banking shares. But there may be indications that the Shanghai composite will resume its downside here.

First, the US dollar has strung together two strong days after comments from Ben Bernanke and the Federal Reserve has investors thinking growth in the US will continue to be propped up. A string of losses from risk currencies could easily seep into other risk assets like commodities and stocks and create a fresh wave of risk-aversion, from which the Shanghai composite will not be immune.

Bringing in another correlation to this discussion, the British pound has been the purest risk currency recently, showing a correlation of more than 87% with the S&P and more than 88% with 10-year euro bonds over the last 34 days. No other major currency boasts a high correlation with the S&P 500 over that time. (The euro sports a better than 86% correlation with 10-year euro bonds.) A break in the British pound could signal a shift away from risk appetite for all markets.)

Second, ETF flows are showing that investors are favoring safer, developed markets:

Investors added $443 million to the SPDR S&P 500 ETF (NYSEArca: SPY) on Wednesday, helping lift total assets in U.S. exchange-traded funds.

The Vanguard MSCI Emerging Markets ETF (NYSEArca: VWO) topped IndexUniverse.com’s redemptions list with outflows of $572.1 million, a sign of the nervousness surrounding ongoing civil unrest and political uncertainty in Egypt.

While inflation, tightening and overheating have all been well-used to describe China’s current predicament, I say again that the risks and impact from potential reactive policy changes have not crept beyond Chinese shares. With pressure emerging faster and more frequently across emerging markets, more emphasis could be put on China’s reaction to its current monetary battles.

Technically, the Shanghai composite took a big step to break above trend channel resistance. There’s a chance it tests the next chart resistance too, as there are likely a lot of buy stops sitting at 2,872:

A chance to get short the risk complex?