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On October 25th, I noted that a bullish divergence seemed to be developing between currencies and the stock market. Specifically, the strength in the "risk-on" Australain dollar (NYSEARCA:FXA) and the weakness in the "risk-off" Japanese yen (NYSEARCA:FXY) stood in marked contrast to the growing weakness and breakdown in the S&P 500 (NYSEARCA:SPY).

For the following two weeks heading into the U.S. presidential election, this conclusion appeared to be the correct call as the S&P 500 drifted up marginally for a 1.1% gain. The S&P 500 dropped 3.5% over the next two days. On Friday, the index held flat as it clung to presumed support at its 200-day moving average (DMA).

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The S&P 500 clings to support

The bullish divergence is also now clinging by a thread.

First, the yen began strengthening the day before the election. On November 5th, the USD/JPY failed to maintain a breakout above the long-term downtrend. The yen acted almost as a first warning sign.

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Breakout above downtrend fails

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Longer-term downtrend in USD/JPY is reaching a "decision point" - breakout or fresh breakdown

On Monday, Nov 12th (Japanese time), Japan confirmed expectations for a contraction in GDP of 0.9% but, according to Reuters, "a decline in capital expenditure was much steeper than forecast." Analysts now expect Japan to sink back into recession. It is very possible of course that markets will extrapolate this to mean that the economies in Japan's export markets are also in decline. While the fresh strength in the yen seems to contradict the worsening economic outlook in Japan, it is consistent with a "risk-off" bias in financial markets.

The Australian dollar has remained quite resilient against the U.S. dollar (NYSEARCA:UUP). Focusing just on AUD/USD, one might guess that the market was relatively boring last week. While the Australian dollar did lose a little ground after the election, it closed last week almost flat.

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The Australian dollar had a flat week and even maintains a short-term upward bias against the U.S. dollar

The big economic news from Australia last week was that employment printed much stronger than expected: the economy added 10.7K jobs versus the 0.5K expected. The week began with the Reserve Bank of Australia balking at cutting rates again despite expectations that it would do so. Both events helped the case for a stronger Australian dollar. Given the Australian dollar has tended recently to directionally lead the S&P 500, I am biased to overweight its signal over the bearish one from the Japanese yen. I am short AUD/JPY as a direct hedge. Note well that the Australian dollar has been rallying strongly against the British pound and the euro for about a month.

Perhaps one of the biggest wildcards is actually the euro. Last week, German manufacturing and industrial production numbers printed weaker than expected. On November 6th, German manufacturing orders printed worse than expected, dropping for the second straight month and the most since September, 2011. On November 8th, Siemens (SI) indicated during its earnings conference call that the company is preparing for slowing global economic growth (but not a "falling off the cliff.") This all likely helped to weaken the euro which is now struggling to hold onto support at its 200DMA. Follow-through downside pressure could further sour the tone for equities.

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The euro clings to its 200DMA versus the U.S. dollar, its bounce from summer lows hanging in the balance

For now, I am net positioned for a bounce in the euro and a reversal in the yen's strength. I think financial markets are oversold enough (based on my latest reading on the percentage of stocks trading below their 40DMAs) to make such a position worth the risk. In the meantime, as usual, I will be watching the Australian dollar most closely for the next directional clues.

Be careful out there!

Source: Yen Breaks Bullish Divergence Supporting S&P 500, But Bounce Looms Given Resilient Australian Dollar

Additional disclosure: In forex, I am net short yen, short Australian dollar, and long euro. Long SI through call options.