With the stock market on the edge of a potentially major breakout, I thought this would be a good time to quickly revisit two recent analyses comparing currency correlations with the S&P 500 (SPDR S&P 500 Trust ETF: SPY). I was looking for confirmation of the increasingly bullish outlook, but I did not get it.
In "Bearish Implications of A Rare Convergence of Extremes in Yen vs S&P 500 Correlations" on April 9th, I calculated rolling correlations between USD/JPY (CurrencyShares Japanese Yen Trust ETF: FXY) and the S&P 500 using 3, 5, 10, 20, 50, and 200-day periods. I concluded that the extreme convergence of the 20 and 50DMAs signaled a sell-off in the S&P 500 given similar outcomes in 2011.
Three weeks later, the S&P 500 peaked. May's performance was one of the worst for the S&P 500 since 1950. The 20 and 50DMAs have converged yet again, along with the 200DMA. Here are the related charts updated with the latest data:
The correlation between USD/JPY and the S&P 500 has already reached an extreme again
This time, the S&P 500 is trying to break out as the rolling correlations have reached extremes together
Source: Prices from FreeStockCharts.com
While the Japanese yen is flashing another warning, the Australian dollar versus the U.S. dollar (AUD/USD) has synchronized with the S&P 500 once again. In "Correlations Are Broken But Australian Dollar Still Leads The S&P 500" on May 26th, I pointed out how the Australian dollar, using the CurrencyShares Australian Dollar Trust (FXA) as a sufficient currency proxy, has frequently led the performance in the S&P 500.
In particular, March's divergence between weakness in the Australian dollar and strength in the S&P 500 served as its own warning sign of imminent weakness in the S&P 500. The Australian dollar and S&P 500 sold off sharply together in May. This near perfect synchronization continues during June's recovery. The charts below update the long-term and short-term views of these relationships.
The Australian dollar versus the S&P 500
FXA versus the S&P 500 since December, 2011
I was hoping for the Australian dollar and the S&P 500 to diverge again to provide a signal for a likely path forward. Instead, my assumption that the Australian dollar will soon resume its downtrend implies that the S&P 500 will also turn south - either together or with the Australian dollar leading the way. Given a sell-off is also consistent with the warning sign from the Japanese yen, I am inclined to remain wary of a sell-off even as other bullish indicators continue to grow.
If June's rally continues, I will stick to the current plan of getting more bullish, but I will be much less aggressive given the yen's warning signal. Moreover, I will look to get aggressively short once (if?) the stock market turns overbought. If instead the rally ends here, I will look to close out most bearish positions in the ensuing sell-off and get more firmly bullish again once (if?) the stock market reaches oversold levels. (I track overbought/oversold levels in my "T2108 Updates").
Recall that the study of the USD/JPY correlations with the S&P 500 are part of an on-going learning process. If after a month or so it appears the signal has actually failed this time, I will revisit the data to determine what other clues need to be considered for the next round. Another phase of quantitative easing from the Federal Reserve is perhaps the biggest wildcard and risk for these bearish projections. Be careful out there!
Additional disclosure: In forex, I am net long the Japanese yen and net short the Australian dollar.