Currencies Are Signaling Potential Bullish Divergences For The Stock Market

Includes: FXA, FXY, SPY, SSO, UUP
by: Duru

This week, the S&P 500 has broken down, providing an early warning that QE3 is not working as expected. The S&P 500 is resting precariously at support formed by the May, 2012 high where the index also experienced one of its largest rallies of the year on September 6th.

The rally from the June lows has broken and yielded to an apparent triple top

Even the U.S. dollar has remained resilient and is near its highest point since QE3 was announced.

The U.S. dollar index has remained resilient post-QE3

The dollar index is now bumping up against the resistance I have assumed would hold at the 50-day moving average (DMA) (and if not, then certainly the 200DMA!).

Against this backdrop, I was surprised that the Federal Reserve did not issue a stronger statement on monetary policy on Wednesday in an attempt to jawbone the market higher. As shown above, both the S&P 500 and the dollar index are at critical junctures and could use some nudging. However, there are two divergent signals that could be pointing to an eventual rally, and they are now tempering my recent bearishness.

First, the Japanese yen has not acted as the safety valve it typically does during such sell-offs. For example, against the U.S. dollar, the Japanese yen strengthened steadily from mid-March and through to the June low for the S&P 500. The yen weakened, as expected, as the stock market bounced, but in less than a month, the yen began strengthening again against the dollar. The weakening of the yen since the June stock market lows is easier to see in the currency pairs with the euro and the pound. The dollar weakened gradually as markets slowly began to anticipate QE3. I post all three charts below.

USD/JPY is strengthening sharply again

The euro has broken out against the yen

The pound continues a long, drawn out recovery against the yen

Since breaking critical support at 78 for the last time in late September, the yen is suddenly weakening sharply against the U.S. dollar. This has occurred even as the stock market has topped out. USD/JPY has even broken above its 200DMA and is re-approaching the long-term downtrend line. The Bank of Japan and the Finance Minister must be extremely relieved that it appears they can take another currency intervention off the table.

The yen's correlation to the stock market has weakened and strengthened in phases, so the current divergence between USD/JPY and the S&P 500 should be treated as just one small signal requiring some confirmation. The Australian dollar may be providing just such a confirmation.

A close-up to show the resilience in the Australian dollar and the recent bounce. Resistance still looms directly overhead.

Source for charts:

I have documented several times and in several ways the strong positive correlation between the Australian dollar and the S&P 500. On Wednesday, a rare event happened. The Australian dollar experienced a nice rally while the S&P 500 sank. The two were buffeted by different forces. The Australian dollar responded positively to a consumer price index (NYSEARCA:CPI) reading that came in much hotter than expected, suggesting that the Reserve Bank of Australian (NYSE:RBA) may have to slow down or even arrest its implied plans to keep cutting interest rates. Soon thereafter, the September China HSBC Flash PMI reading came in a little stronger than expected, hitting three-month highs as the Chinese economy shows some signs of revving up again. I can only assume the weak trading on the S&P 500 represented some kind of disappointment that the Federal Reserve did not do any cheerleading for the U.S. stock market or the economy.

I consider the divergence between the Australian dollar and the S&P 500 to be a nascent bullish sign. One day does not a trend make, but the higher the Australian dollar goes, the more bullish (or less bearish) I have to get by rule. The irony is that I just turned bearish based on the S&P 500′s recent breakdown. In the meantime, my call options on ProShares Ultra S&P 500 (NYSEARCA:SSO) to play a presumed, short-term Fed-driven bounce are suffering. Perhaps these currency-driven bullish divergences will place them in the green after all.

Be careful out there!

Disclosure: I am long SSO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In forex, I am long EUR/JPY