The Australian Dollar Breaks Out And Regains Correlation With The S&P 500

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 |  Includes: FXA, SPY, SSO
by: Dr. Duru

On Thursday, January 10th, China reported export growth much larger than forecasters expected. According to Reuters, the consensus forecast was for year-over-year growth of 4% and actuals came in at 14.1%, marking a 7-month high. This surge helped push the Australian dollar (NYSEARCA:FXA) far enough to finally break a long-standing downtrend against the U.S. dollar.

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The Australian dollar FINALLY breaks its downtrend versus the U.S. dollar

The timing of the breakout is notable because at the same time, the S&P 500 (NYSEARCA:SPY) rallied to the edge of last year's triple top, the first leg of which occurred on September 14th, the day after the U.S. Federal Reserve announced QE3. Also on September 14th, the Australian dollar printed a fresh 6-month high against the U.S. dollar before fading away all its gains for that day.

As the chart above shows, AUD/USD proceeded to sell-off for over three weeks from that point. At the same time, the S&P 500 managed to re-challenge its highs. Two weeks later, the S&P 500 made one last run at its highs, forming the last leg of the triple top. However, the Australian dollar was in the middle of what would become a near 3-month recovery period.

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The S&P 500 challenges the first and highest leg of the triple top

Source for charts: FreeStockCharts.com

In other words, the typically strong correlation between the Australian dollar and the S&P 500 that I have frequently referenced had broken. The correlation is now poised to re-establish itself with the breakout of AUD/USD and the testing of 52-week and multi-year highs by the S&P 500. The key to resolution of this convergence may be iron ore prices.

There were two primary confounding factors when the Australian dollar lost its correlation with the S&P 500: a more dovish Reserve Bank of Australia (RBA) that was cutting rates and wild swings in the price of iron ore.

The RBA must be ready to pull its collective hair out as its stubborn currency remains defiant. The RBA has dropped rates partly in a campaign to weaken the Australian dollar in anticipation of economic softness in 2013 as declining terms of trade begin to cascade through the Australian economy. The currency markets have essentially ignored these efforts except for brief bursts of activity that largely did not correlate with moves in the S&P 500.

More importantly, the Australian dollar has pivoted on swings in iron ore prices. Last August, the blog "Brazilian bubble" posted a chart showing the strong correlation between the Australian dollar and iron prices with this summary:

The rolling annual correlation over the entire period 2005 to current runs at around 70%, and through 2008-2010 this was closer to 90%. By contrast, in the year to date correlation is running at just 12%.

The decoupling occurred as iron ore peaked early in 2012 at $148/ton and then sold off steeply from July to September, hitting a 3-year low at $87/ton (see Figure 2 on page 52 of the December, 2012 Resources and Energy Quarterly from the Australian Government Bureau of Resources and Energy Economics). Following/leading the stock market, the Australian dollar plunged to its lows for the year at the beginning of June. It rallied through the first half of the large sell-off in iron ore before joining the selling in August. Since then iron ore has rebounded sharply, with a marked acceleration over the past month. In just four months, iron ore has gone from three-year lows to 15-month highs.

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Iron ore prices have swung wildly over the past 12 months

Source: The Sydney Morning Herald

Note that the Australian dollar actually sold-off during the first half of the acceleration in iron ore prices in December. It seems that instead of a tight correlation, iron ore is now leading the Australian dollar. With iron ore prices stretched far above average forecasts for the year and the S&P 500 extremely overbought, the entire chain from iron ore to the Australian dollar to the S&P 500, seems ready to tumble. A process which would firmly re-establish correlations with an exclamation point. Indeed, I have maintained a fresh short position on AUD/USD and puts on ProShares Ultra S&P500 (NYSEARCA:SSO) in anticipation of some kind of pullback in the coming week or so.

Whatever happens, I will be watching closely how these correlations resolve themselves. A continued rally across the board would be a powerful confirmation of bullish momentum in financial markets. A coordinated pullback might confirm that markets have rallied beyond what the economic fundamentals will support. If these three participants - AUD/USD, the S&P 500, and iron ore - go their separate ways again, I will be back at the white board figuring out who is leading whom.

Be careful out there!

Disclosure: I am short SSO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short SSO through puts. In forex, I am short AUD/USD.