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A reader recently asked the following questions in response to my last piece on the relationship between the Australian dollar (NYSEARCA:FXA) and the S&P 500 (NYSEARCA:SPY) (A Bearish Divergence As Australian Dollar Stalls While S&P 500 Jumps):

This article is fascinating too (just read your AAPL article on daily variances). The question I have though is this: What is the hypothesis for the correlation? Maybe it went over my head, but I missed the reasoning besides the observation. Maybe that alone can be significant, but it sure puts a lot of faith in possible random coincidence.

BTW, I went back to read a couple other of your articles regarding the strength of the AUD and all of the looming headwinds for the economy (iron ore prices and growth in China slowing). But I didn't make the connection still. Any thoughts Doc? or anyone else too. Thanks

You can find my initial response by clicking here, but I thought I would take some time to give an even more complete response. Note that I have taken extended looks at the data supporting the consistent relationship between the Australian dollar and the S&P 500. For example, see Correlations Are Broken But Australian Dollar Still Leads The S&P 500.

My current hypothesis for the relationship between the Australian dollar and the S&P 500 is this:

The same traders and investors who are chasing the Australian dollar higher are the ones chasing the S&P 500 higher, or at least the types of buyers are very similar. These buyers are looking for relative yield and safety. Some number of these traders are doing carry trades, borrowing low-yielding currencies to buy high-yielding currencies and relatively "safe" equities.

Amongst the major "Western-style" economies, Australia remains one of the most resilient. Similarly, the U.S. market with its liquidity and stabilized economy offers relative safety from European woes (and Japanese ones for that matter). Given the Australian market's smaller size relative to the U.S., bearish and bullish turning points can manifest earlier in forex in Australia. Australia can be the "canary in the coal mine." That is, when these kinds of traders and investors make a change, the ripples show up first in the smaller market of Australian currency crosses. The impacts cascade or radiate from there as more and more traders take their cues from each other. The speed of transmission, and whether traders in the more liquid market lead the way, will certainly depend on the comprehensiveness or universality of the looming catalyst.

In summary, turning points should show up in Australia first given its smaller size relative to the market for U.S. financial instruments. The highly correlated trading occurs because the motivations for pursuing higher relative yields in currencies and higher relative safety (equating to returns) in equities are closely related. This correlation will likely only break down if, for example, the Australian economy experiences a country-specific calamity.

There is significant disagreement in the financial community about the fundamental health of the Australian economy and its future prospects. This primarily involves guesses about China's health and the relative resilience of the non-commodity based segment of Australia's economy. However, given the Reserve Bank of Australia's (RBA) recent focus on Europe as its primary risk, I have taken the edge off my bearishness on the Australian dollar. I am awaiting this week's RBA minutes as my next chance to make more adjustments to my assumptions.

Note as well that no matter what hypothesis I use to explain the close relationships between the Australian dollar and the S&P 500, the data to test the hypothesis is hard to come by (and extremely expensive for a retail investor!). I personally have no problem using a signal that works even as its underlying gears are difficult to decipher. There are a LOT of mysteries in the financial market, and if you try to explain all the madness, you yourself could go mad. I fully recognize that these convenient correlations will (should?) eventually fail, perhaps only in episodic fashion, but I may only recognize the failure with hindsight. Given these analytic limitations, it does make sense to treat these relationships with a healthy dose of caution.

On a related note, I have mentioned in previous posts that I would cobble together the evidence and explanations I see and hear for the Australian dollar's strength. I present here select commentary from the always insightful guests on "Hard Currency" the Financial Times' weekly currency podcast. Host Alice Ross has asked more and more questions about the baffling Australian dollar as its strength seemingly continues to defy the "fundamentals." (I also find these summaries very useful for my own comprehension of the best thinking out there).

July 8th, 2012
Title: "Why QE doesn't necessarily weaken currencies"
Guest: Elsa Lignos, RBC Capital Markets
Related highlights: The ECB rate cut has motivated carry trades by making the euro (NYSEARCA:FXE) attractive as a funding currency. Quantitative easing (QE) could be effective for supporting the euro as it reduces the risk premium (that is, plenty of euros sloshing through the system to support liquidity). The Swiss National Bank (SNB) is likely driving forex markets by recycling the euros it buys into other currencies to support the cap on the Swiss franc (NYSEARCA:FXF) against the euro. The International Monetary Fund's (IMF) data on Q1 reserves showed the first slowdown in "a while" of holdings in other currencies. The Q2 data (available at the end of Q3) should show an increase in flows.

July 15th, 2012
Title: "Traders Focus on Yields"
Guest: Simon Derrick, BNY Mellon
Related highlights: Commodities currencies are doing well despite a very mixed performance on commodity prices. Traders are looking for yield and this could become THE theme for the second half of the year. The ECB is likely to be the most accommodative central bank for quite some time. Traders are not yet using the euro as a funding currency, but they are looking into it. The evidence of the euro's participation in the carry trade may come when it RISES on "risk-off" days. Maybe in 12-18 months, once tensions dissipate, the carry trade will become "comfortable." "Nice high rates" will keep the Australian dollar high so even a cut to 3% will have little impact. Demand from investors and central banks will keep the currency high no matter what happens to commodity prices. This is all about yield, the search for positive return. The same applies to the Canadian dollar (NYSEARCA:FXC) (whose rate is only 1%).

July 22nd, 2012
Title: "Traders Focus on Yields"
Guest: Matt Cobon, Threadneedle Asset Management
Related highlights: Cobon remains fairly negative on the fundamentals of the Australian economy and global growth dynamics. Australia's two-tier economy (commodity and non-commodity) is slowing while the market is pricing toward the commodity super cycle. It is not likely that China's economy will continue at its previous high rate of growth as the market seems to be assuming. The Australian dollar could fall a lot lower in due time.

In a world of low volatility and low yields, the Australian dollar has become a great place for people to hide. Moreover, the Australian bond market has become dominated by foreign ownership, increasing from 65% to 83% in the last couple of years. (When foreigners buy Australian bonds, they must convert their native currencies into Australian currency, thus pushing up the value of the Australian dollar). The euro is definitely becoming a funding currency in addition to the U.S. dollar. It is all about relative policy differentials. Dynamics could change with the end of the summer.

The lesson over the past six to seven years or is not to underestimate the impact of central bank diversification, especially in summer markets when liquidity is very light. It is very difficult to step in front of the "elephant" that is accumulating reserves at a rapid pace. Volatility is at "crazily low" levels, certainly for the year and near the lows since the Lehman Brothers crisis. These low levels are fundamentally wrong. If a sell-off happens, it will likely be in September once people focus again on what's "really happening."

August 5th, 2012
Title: "Is Switzerland the New China?"
Guest: Kit Juckes, Société Générale
Related highlights: The SNB is now sixth in the world in the size of its foreign reserves. The recycling of euros generates a negative feedback loop that creates additional downward pressure on the euro. The euro will remain weak - outside the occasional short-covering rally - as Mario Draghi gives the impression that he is running out of options: "Any day we are frightened about anything, the euro will get hit." The Australian economy is looking better than expected. Housing prices and consumer demand are recovering. Financial markets had been expecting significant rate cuts, and they are rethinking that. Money looking for returns floods into Australia. The Reserve Bank of Australia (RBA) will soon have to choose between having rates that are lower than warranted by the economy or a currency that is stronger than it should be. The RBA will likely allow the currency to appreciate further. The Australian dollar correlates better with a broad basket of currencies and not just the commodities Australia exports. The long-term concern is whether Chinese demand dries up, but such a decline is not likely to happen.

August 12th, 2012
Title: "Mixed News for Sterling"
Guest: Javier Corominas, Record Currency Management
Related highlights: No additional amount of QE or stimulus will result in more demand in Western economies as they face a structural deleveraging. What is primarily driving currency markets right now is the demand for economies with current account surpluses and relatively higher yields. We should see some mean reversion in the euro against the major currencies as the ECB has taken away tail risk. In the pre-2008 world (2003-2007), the carry trade was the dominant theme in currency markets and trending before that. In the new world of risk-on/risk-off, it is much more difficult for traders to harvest the pre-2008 style trading. So, demand for safe haven currencies has risen in economies with structural current account surpluses. This is a paradoxical world where there is demand for both the high-yielding Australian dollar (real returns over inflation) and the yen for safe haven demand. So, AUD/JPY has been mean reverting.

-end summary-

For the very short-term, I have switched back to a long Australian dollar bias to play a quick bounce. After this position runs its course, I will be scaling back significantly with a preference for watching and observing how the summer ends and the fall trading begins. Stay tuned and brace yourself.

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 currently net short the euro and net long the Australian dollar