I have written several articles now discussing the dynamics of the Australian dollar as well as its correlation with the S&P 500. At the end of May, I wrote "Correlations Are Broken But Australian Dollar Still Leads The S&P 500" and demonstrated how the decline in the Australian dollar versus the U.S. dollar in March potentially provided a leading indicator of the eventual peak of the year for the S&P 500. Friday's trading showed once again how traders might be able to use divergences between the Australian dollar and the S&P 500 to guide short-term trading.
The market sold-off on the heels of another disappointing jobs report, capping a week of disappointing U.S. economic data. When the S&P 500 hit a new low for the day ahead of 2:30pm (often a critical turning point for intraday trading), the market appeared set up for a new wave of selling to close out the day. Instead, the market rallied vigorously into the close although still down overall for the day.
Fund manager Doug Kass cited a WSJ article as a possible explanation for the turn-around (he tweeted late Friday afternoon the following: "Hilsenrath/WSJ article at 345PM causes late day rally…I shorted more into the silliness…"). In "Weak Report Lifts Chance of Fed Action" author Jon Hilsenrath turned lemons into lemonade by explaining how the poor economic data could finally motivate the Federal Reserve to launch QE3. This ongoing hope likely explains why the S&P 500 is faring so well despite the sinking economic data all around the globe. The soaring U.S. dollar likely demonstrates how bad (relatively) things are outside U.S. borders. The Federal Reserve must indeed be getting nervous with the dollar index returning to its QE2 price (the level for the U.S. dollar right before QE2 was telegraphed at the end of August).
The U.S. dollar index is again pressing against QE2 resistance and now looks ready to break it
Although the U.S. dollar index remained strong into the close, the Australian dollar rallied strongly into the close. In fact, while the S&P 500 made a new low for the day ahead of 2:30pm, the Australian dollar (against the U.S. dollar) did not. This divergence, a bullish divergence, may have served the attentive trader well on Friday no matter what explains the closing rally. Going forward, I am certainly going to monitor weekly, daily, AND intra-day divergences between the Australian dollar and the S&P 500. In the chart below, the thick red line represents the Australian dollar versus the U.S. dollar in foreign exchange (AUD/USD) and the black (jagged) line represents the S&P 500. The black horizontal line represents the Australian dollar's low for the day.
The Australian dollar fails to make a new intra-day low when the S&P 500 prints its fresh low on the day
Even if this divergence was not a buying signal, it could have delivered a short-term signal for shorts to reduce positions as a way of tightly managing risks. Given the stock market is very overbought, I was surprised to see such a strong close. Regardless, the S&P 500 has now failed at resistance formed by the 2011 high, and the overall upward momentum from the June low still holds. The next big move comes once either this resistance breaks or the upward momentum ends. In the meantime, the bulls maintain overall advantage…at least until the Australian dollar indicates otherwise!
S&P 500 turns away from resistance at the 2011 high
Source for charts: FreeStockCharts.com
Be careful out there!
Additional disclosure: In forex, I am net short the Australian dollar and the U.S. dollar