The Australian Dollar Stands Between Here And A Larger Correction

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Includes: CROC, FXA, FXY, GDAY, SPY
by: Duru

Summary

Australians seem to be pondering larger implications of their plunging currency.

While the ultimate implications may be unclear, the sympathetic link with trading in the S&P 500 is a lot more clear.

The current trading in the Australian dollar suggests that the S&P 500's correction is already reaching an end...but watch how it trades against the Japanese yen for potential confirmation.

In "The dollar keeps falling: What's happening to our economy?" Gareth Hutchens of the Sydney Morning Herald tries to explain to the everyday reader how the Australian dollar's (NYSE:FXA) twists and turns relate to Australia's economic prospects. Hutchens cites the U.S. dollar and Australia's plunging terms of trade as factors driving down the Australian dollar's exchange rate. For both cases, he explains market assessments of events that will supposedly happen earlier than "experts" had expected. Yet, the release of the minutes from the Federal Reserve's September policy meeting confirmed that the Fed as a group is in absolutely no rush to raise interest rates. The terms of trade are falling just as the Reserve Bank of Australia (RBA) has anticipated and has been warning for a very long time. I am not sure why the "experts" have refused to believe the RBA on this score.

Anyway, Hutchens goes on to explain some of the mechanics of how the currency's moves ripple through the Australian economy. It is is difficult to come to a final conclusion because Hutchens identifies two distinctly counter-acting forces: a drop in Australian earnings repatriated into the country versus more competitive pricing of Australian exports which could increase export volumes. The key of course can Australia make up on volume what it loses on price. So far, it is not looking good with the persistent plunge in ore prices that has little to do with the exchange rate and a lot to do with the insistence of major miners to continue dumping massive supplies on the market. At the end of the article, the same improving U.S. economy that is cited as driving up rate expectations in the U.S. is cited as a reason for analyst optimism that the Australian dollar will not drop further than 0.80 to 0.85 against the U.S. dollar.

One thing seems clear if trading on the S&P 500 (NYSEARCA:SPY) is any indication: the Australian dollar is sympathetic with, and perhaps even linked to, market sentiment in the U.S. The Australian dollar has stood between "here" and a market correction twice already this year, and it could very well signal the difference this time around as well.

In particular, the Australian dollar combined with the Japanese yen (NYSE:FXY) has repeatedly come through as a key indicator for navigating a period of increased volatility for the S&P 500 . I discussed the prospects for this signaling at the end of last year.

During the current sell-off, the Australian dollar versus the Japanese yen (AUD/JPY) failed to respond to stock market angst from September 29th to October 8th. It traded in a tight range just above its 200-day moving average (DMA). I used that signal to anticipate bounces from two oversold conditions on the S&P 500. On October 9th, AUD/JPY finally decisively broke down while the S&P 500 careened into its third oversold condition in just 8 trading days. While the S&P 500 closed at a fresh 2-month low, it did not trade below the intraday low of the previous day. However, AUD/JPY's weakness made me cautious, and sure enough, the next day, the S&P 500 finally followed through with selling that took it to a critical test of the S&P 500.

Here is the story in charts:

The S&P 500 slams into is most critical test since the 200DMA last cracked in November 2012

AUD/JPY failed to confirm the last all-time high on the S&P 500 and for two trading weeks failed to confirm the on-going selling on the S&P 500

What is more clear from hindsight is that AUD/JPY also failed to confirm the last all-time high on the S&P 500. This lack of confirmation was important because AUD/JPY neatly marked the S&P 500's bounce from the July/August sell-off and rallied right along the S&P 500 until the previous all-time high on September 5th. On September 9th, AUD/JPY traded sharply lower and broke its primary uptrend and contributed a fresh signal that the S&P 500's upward momentum was ending.

At the time of writing, AUD/JPY is experiencing a nice bounce from what currently looks like a move downward that washed out a good amount of selling angst. If the relationship holds as expected, the U.S. stock market should open strong and close with a gain on Monday, October 13…setting up yet another bounce from oversold conditions. An intraday chart makes the possibilities more clear.

A bottom-forming bounce my finally be underway

Meanwhile, the potential bottom I identified in the Australian dollar versus the U.S. dollar is still holding after almost two weeks. This could be the ultimate lack of confirmation of the S&P 500's most recent weakness. Note that like AUD/JPY, AUD/USD started its move off the 2014 low in January about a week ahead of the bottom in the S&P 500 at the time. AUD/JPY performed much better than AUD/USD as an indicator of a bottom in the July/August sell-off. Thus, I have every reason to continue to prefer AUD/JPY as an indicator.

AUD/USD has bounced wildly off the 2014 low in October

The wild swings in AUD/USD correspond to the wide swings in the S&P 500 which have facilitated a volatility index, the VIX, that finally broke out to a fresh high for the year at one point in trading on Friday, October 10th.

None of these observations demonstrate that the Australian dollar is driving the trading action in the S&P 500. Instead, they suggest that the Australian dollar is still serving as a sufficient signal to confirm, indicate, and even predict the trading action. The currency is of course also not the only useful indicator. As I indicated earlier, the main link likely exists in correlated market sentiment and trading psychology. Going forward, breaks of these relationships will be just as important as confirmations.

Because of the Australian dollar's resilience at its 2014 bottom versus the U.S. dollar and because of my anticipation of another bounce from oversold conditions (led by AUD/JPY of course), I closed out my last bet against the Australian dollar and sit 100% long the Australian dollar for the first time in a very long time. This positioning can change in a hurry, and I am bracing myself given on-going volatility.

This 100% long position is not easy for me since I am inclined to remain bearish on the currency. For now, short-term price action rules. Moreover, recall that I used Australia's Bureau of Resources and Energy Economics (BREE) forecasts to estimate that the Australian dollar would survive its 2014 low against the U.S. dollar. So far, so good.

Be careful out there!

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In forex, I am long the Australian dollar and short the Japanese yen.