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I have written multiple times about the usefulness of the Australian dollar (NYSEARCA:FXA) as an early indicator or confirming signal for directional trading on the S&P 500 (NYSEARCA:SPY). For an example, see "Another Key Bullish Divergence Between The Australian Dollar And The S&P 500". I have stayed on alert for any signs of a bearish divergence between the Australian dollar and the S&P 500. Such a critical juncture may have finally arrived.

The Australian dollar experienced an important breakout against the Japanese yen last week. The currency has made little progress since then. Even more importantly, the Australian dollar has stalled out against the U.S. dollar. At current levels, AUD/USD rests at the April highs which served as an important breakout point in late July and early August. Meanwhile, the S&P 500 has broken out toward fresh multi-year highs.

(click to enlarge)

The Australian dollar has stalled against the U.S. dollar and a breakdown looms

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S&P 500 breaks out to within inches of a new 4+ year high even as volume remains low

Source: FreeStockCharts.com

If history repeats itself, this early divergence between AUD/USD and the S&P 500 (on a daily level) could signal the beginning of the end for the current rally in stocks despite the increasingly bullish outlook. The last major divergence occurred after AUD/USD last topped out in late February of this year. After dipping sharply in early March, the S&P 500 soared to fresh multi-year highs later that month. A sharp cascade downward followed to the June lows. So, it is very possible that the S&P 500 can continue running with the baton but without the Australian dollar returning to the race, the stock market should experience a significant correction.

Taking this one step at a time, AUD/USD must first break the support shown in the above chart. That event will be the first warning signal. As long as the Australian dollar weakens from that point forward, I will expect a swift sell-off in the S&P 500 at any time. The depth and duration of that correction will likely be signaled by the subsequent behavior in the Australian dollar. Similarly, the higher the S&P 500 rallies without participation from the Australian dollar, the more steep the subsequent correction.

As a reminder, I remain aware that these amazingly consistent relationships must almost surely come to an end at some point, and that end may only become clear in hindsight. However, for now, the Australian dollar continues to behave as a useful trading tool.

Be careful out there!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: In forex, I am net short the Australian dollar

Source: A Bearish Divergence As Australian Dollar Stalls While S&P 500 Jumps