The Australian Dollar May Reveal The Outlook For U.S. Equities

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 |  Includes: BZF, CRB, DBC, FXA, USO
by: Matthew Claassen

Although we would not want to demean the importance of the inverse relationship between the U.S. Dollar Index and the commodity and equity markets, evidence indicates that the positive correlation between the currencies of commodity producing economies and the U.S. equity and commodity markets is a significantly stronger and more meaningful relationship. Because of this, investors in equities and commodities should be more focused on the currencies of countries like Australia, Canada and Brazil as a leading or coincident indicator of the market trend and health of global economies.

The U.S. Dollar Index is heavily weighted toward commodity-consuming economies, rather than commodity producers. The current weighting consists of 58.60% vs. the euro, 12.60% vs. the yen, 11.90% vs. the pound sterling, 9.10% vs. the Canadian dollar, 4.20% vs. the Swedish krona and 3.60% vs. the Swiss franc. Of these, only Canada is a commodity producer.

In the first chart below, we illustrate the relationship between the S&P 500 and an inverted U.S. Dollar Index. It can be seen that there are periods of strong correlation. However, because of the Dollar Index’s higher volatility, there are also periods like February through April of 2010 or May 2011 and others where the correlation broke down.

S&P 500 with Inverted U.S. Dollar Index

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To provide a more focused perspective of the U.S. dollar’s potential effect on commodity prices, we maintain an equal weighted composite of currencies from commodity-producing economies. The second chart below illustrates the S&P 500 during the same time period, but includes our equal weighted composite of currencies of commodity producers (orange). This composite is not inverted.

It’s visually apparent that the positive correlation between the composite is notably stronger than the inverse correlation of the U.S. Dollar Index. It should also be noted that while the U.S. equity market has a generally negative response to a rising dollar, the equity indices of commodity producing countries like Australia, Canada and Brazil tend to trend in the same direction as their respective currency. In other words, when the currencies of commodity producing countries are in a declining trend, so are both their equity markets and U.S. equities.

S&P 500 with Composite Currencies of Commodity Producers

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In the third chart below we have substituted the Australian Dollar ETF (NYSEARCA:FXA) in place of our composite and included the Commodity Index (Pending:CRB) and crude oil. The sharp decline during the 2008 bear market period was also the weakest period for the equity markets. Because of deflationary pressures, commodities, equities and Treasury yields have trended in a positive correlation since 1998. Thus, the weakest periods of the equity markets since this secular bear market started in the year 2000 has been when the currencies of commodity producing economies are declining along with commodities.

Australian Dollar ETF (FXA) with WTIC Crude Oil and CRB Commodity Index

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In a separate research report, available on request to registered users of our website at no cost, we detail our analysis of why we believe the currencies of commodity-based economies have recently ended their cyclical bull market, and provide minimum price targets for the months ahead. This is the same analysis we used to forecast the top in the oil prices earlier this year and post a minimum price target of $67 to $70 per barrel when WTIC oil was still above $110.

Considering the correlations between commodities and currencies like the Australian Dollar detailed above, if the currencies of commodity based economies have indeed peaked, there remains a great deal of risk and downside potential in U.S. and global markets. If intermarket correlations maintain the relationships they have held for the past 13 years, the strongest part of the bear market in U.S. equities is yet to come. However, because of the recent high volume sell-off, we would caution that a multi-week to multi-month rally in equities would be normal prior to the next leg down. Historically, that rally would retrace approximately half of the losses that precede it.

ETF investors can use the Australian Dollar ETF, U.S. Oil ETF (NYSEARCA:USO), Canadian Dollar ETF (NYSEARCA:FXC), Brazilian REAL ETF (NYSEARCA:BZF) and DB Commodity Index (NYSEARCA:DBC).

Disclosure: I am short FXA.