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The Australian dollar versus the U.S. dollar has served as a proxy for commodity prices, Chinese economic growth, and/or the health of the global economy. This currency has been highly correlated with the S&P 500 for much of the last six years and more. The correlation has broken down at critical moments, the most interesting of which occurred with the Australian dollar emerging as a leading indicator.

The first important correlation breakdown since 2006 was in 2008 when commodity prices soared in a last gasp before the global economy plunged into recession. While the S&P 500 sank for the first seven months of the year, the Australian dollar continued to soar to new heights. Then, suddenly, the Australian dollar plunged about 20% in two months while the S&P 500 remained flat. Two weeks later, both the Australian dollar and the S&P 500 plunged together as the financial panic took an extra urgency in the wake of the collapse of Lehman Brothers. While the S&P 500 went on to make fresh multi-year lows in March 2009, the Australian dollar never went lower. In other words, the Australian dollar served as a non-confirming signal of the sell-off in the S&P 500. It was a leading indicator of a bottom. (I wish I had been paying attention to this potential relationship during that time!).

The Australian dollar again served as a non-confirming signal when the S&P 500 made a 2010 low at the end of June and beginning of July, 2010 while the Australian dollar was already a month into its bounce from 2010 lows.

In 2011, things changed a bit. When the S&P 500 retested 2011 lows on October 1st, the Australian dollar dropped in sympathy. The two dropped together the next month as well.

The chart below describes this action on a percentage basis starting from 2006. I use FXA as a sufficient proxy for the AUD/USD currency pair. FXA is represented as a "mountain chart" and the S&P 500 is the red line.

(click to enlarge)The Australian Dollar (NYSEARCA:<a href='http://seekingalpha.com/symbol/fxa' title='CurrencyShares Australian Dollar Trust ETF'>FXA</a>) versus the S&P 500The Australian Dollar versus the S&P 500

Source: Yahoo Finance

This year, the Australian dollar peaked during the month of February while the S&P 500 continued to rally. In March, the two indices directly diverged, and my "love affair" with the Australian dollar officially came to an end. In April, the S&P 500 peaked for 2012 to-date while the Australian dollar stabilized. This month, both the Australian dollar and the S&P 500 have suffered steep losses. Taken together, the peak and subsequent sell-off in the Australian dollar served as a leading indicator of the peak and sell-off in the S&P 500.

(click to enlarge)FXA versus the S&P 500 since November, 2011FXA versus the S&P 500 since November, 2011

Source: Yahoo Finance

So what now? It seems the odds favor the Australian dollar serving as a leading indicator again. The Australian dollar's decline has been persistent as the market rushes to price in a much more aggressive monetary easing in Australia. If instead the Reserve Bank of Australia (RBA) proceeds cautiously, as I think it will, the Australian dollar should stabilize around parity with the U.S. dollar. If the U.S. Federal Reserve finally responds to global economic developments with its own additional easing, then I will be even more certain of such stabilization. As always, Chinese economic conditions represent the over-arching wildcard. With these assumptions in mind, here are the scenarios I am actively monitoring for trading opportunities:

  • A stable Australian dollar and fresh lows on the S&P 500 will make me an aggressive buyer of stocks. Note that the stock market is still hovering just above oversold levels.
  • A continuing sell-off in the Australian dollar will keep me overall bearish on the S&P 500.
  • A rally in the S&P 500 that leaves the Australian dollar behind will motivate me to find a spot to fade stocks at critical resistance levels.

In the meantime, I continue to hold a small bullish position in the Australian dollar against the U.S. dollar, the Japanese yen, and the Swiss franc while actively swing trading the Australian dollar short using the British pound (GBP/AUD). It has not been an easy trade - especially when I have had to take on very large long positions in GBP/AUD and/or large long positions on other Japanese yen currency pairs - but I want to be properly positioned for any rapid depreciation in the U.S. dollar, Japanese yen, and/or Swiss franc in the wake of currency interventions and/or aggressive easing measures. I figure the odds are very high for at least one of the three currencies to sharply weaken in coming weeks.

Be careful out there!

Source: Correlations Are Broken But Australian Dollar Still Leads The S&P 500

Additional disclosure: In forex, I am net long the Australian dollar, net short Swiss franc, net neutral Japanese yen