With A Rate Decision Looming, Weakening Australian Dollar Sends Poor Signal For Stocks

While all eyes are trained on U.S. economic data this week, Australians are looking ahead to Monday, February 4th when the Reserve Bank of Australia (RBA) makes its next statement on monetary policy. Consensus forecasts pin rates right where they stand at 3.0%. Yet the Australian dollar (NYSEARCA:FXA) has traded steadily downward against all major currencies except the Japanese yen (NYSEARCA:FXY) going into this meeting, as if the odds are relatively high that the RBA will cut rates yet again.

The weakness is particularly notable against the euro (NYSEARCA:FXE), currently one of the strongest of the major currencies.

While the euro remains significantly down versus the Australian dollar, the recent rally has taken EUR/AUD 13% off August lows

The Australian dollar is now slightly down year-to-date against the U.S. dollar…

AUD/USD cracks support at its 200DMA for the first time since October as it goes negative for 2013

The line in the upper-right part of the graph marks the downtrend that remains in place since the Australian dollar hit an all-time high against the U.S. dollar in 2011 as iron ore prices soared to a record peak. I earlier argued that downtrend would likely re-establish itself even as the Australian dollar appeared to break out on January 10th. I figured iron ore prices were set to cool off after an extremely sharp relief rally from last year's collapse. Those prices have indeed cooled, and the Australian dollar has cooled off as well.

The Australian dollar's slightly negative performance this year against the U.S. dollar has occurred despite the strong January rally in the S&P 500 (NYSEARCA:SPY) that has generated a 5.0% gain. This means the typically strong correlation between the Australian dollar and the S&P 500 is once again broken. In fact, this correlation has trended downward over the past year or so as the Australian dollar has failed to make further gains as the S&P 500 has churned higher. Here is a list of correlations between the daily price change in the S&P 500 versus the daily price change in FXA (as of January 30, 2013):

  1. Since 2007: 0.68
  2. Since 2008: 0.70
  3. Since 2009: 0.74
  4. Since 2010: 0.75
  5. Since 2011: 0.74
  6. Since 2012: 0.67
  7. 2013 only: 0.56

Notice that in the years following the financial crisis, the Australian dollar recovered in near lock-step with the S&P 500, even out-performing the index in 2010. When the correlation significantly broke in 2012, I noted how the Australian dollar still provided a leading indicator of coming weakness in the S&P 500 (see "Correlations Are Broken But Australian Dollar Still Leads The S&P 500"). With the stock market significantly overbought, I strongly expect that the current weakness in the Australian dollar is providing the same early signal it did in 2012. The RBA may hold the final key.

When the RBA makes its statement, it will need to explain whether it still thinks the Australian economy is still headed for a cool down thanks to terms of trade that have peaked from falling commodity prices. I also expect the RBA to at least hint at its bias for interest rates and the currency by walking a very fine line. On the one hand, it cannot justify even lower rates given all the talk about global economic recoveries, especially a stronger second half for Europe, more economic stimulus in China, and strong financial markets around the globe. On the other hand, the RBA has made it clear that continued strength in the currency is not consistent with a healthy economy going forward. If the RBA tips its hand toward the strengthening global economy, I expect the Australian dollar to rebound sharply. If the RBA surprises with a rate cut, I expect an acceleration in weakness given the dire signal such a cut would send. In other words, the RBA will tread VERY carefully.

Even if the Australian dollar rebounds after the RBA announcement, I think the overall downtrend will soon reassert itself. The S&P 500 should soon follow weakness in the Australian dollar for a notable but small correction in February. A tentative target will be a reversal of all of 2013′s gains except the 2.5% jump that began the year. Note that this correction remains very consistent with the ongoing bullishness signaled by the "Black Friday" trade.

The S&P 500 has churned higher slowly but relentlessly since the start of 2013

Source for charts: FreeStockCharts.com

Disclosure: I am short SSO through put options. 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.