- a major net oil importer - has suffered the most.  

Over the past three years (2003-2005), the correlation between the Canadian dollar and oil prices has been approximately 80%. Canada is the ninth largest producer of crude oil in the world, and it continues to climb up the list, with production in oil sands increasing regularly. In 2000, Canada surpassed Saudi Arabia as the United States' most significant oil supplier. Unbeknownst to many, the size of Canada's oil reserves is second only to those in Saudi Arabia. The geographical proximity between the U.S. and Canada, as well as the growing political uncertainty in the Middle East and South America, makes Canada one of the more desirable places from which the U.S. can import oil. But Canada does not service only U.S. demand. The country's vast oil resources are beginning to get a lot of attention from China, especially since Canada has recently stumbled upon a new stash of oil after a reclassification of its Alberta oil sands to the "economically recoverable" category. This makes the Canadian dollar one of the currencies best positioned to benefit from an ongoing surge in oil prices. 

The chart below shows the clearly positive relationship between oil and the Canadian loonie. In fact, it should come as no surprise that the price of oil actually acts as a leading indicator for the price action in the CAD/USD. Since the traded instrument is the inverse, or USD/CAD, it's important to note that based on the historical relationship, when oil prices go up, USD/CAD falls. 

Figure 1 - A look at the correlation between the price of oil and the price action in the CAD/USD from December 2002 to September 2005

Oil and the Japanese Economy
At the other end of the spectrum, Japan imports 99% of its oil (compared to the U.S., which imports 50%). It is one of the world's largest net oil importers. Japan's lack of domestic sources of energy, and its need to import vast amounts of crude oil, natural gas and other energy resources, makes it particularly sensitive to changes in oil prices. Japan also lacks the flexibility to switch to nuclear power because it is a huge net importer of uranium for its nuclear power plants. In 2003, the country's dependence on imports for primary energy stood at more than 79%. Oil provided Japan with 50% of its total energy needs, coal with 17%, nuclear power 14%, natural gas 14%, hydroelectric power 4%, and renewable sources a mere 1.1%. Therefore, when oil prices skyrocket, the Japanese economy suffers.

An Attractive Oil Play: CAD/JPY
Looking at this from a net oil exporter/importer perspective, the currency pair that tops the list of currencies to trade to express a view on oil prices is the Canadian dollar against the Japanese yen. In fact, over the past two years, CAD/JPY has had an 85% positive correlation with oil prices. As we can see in Figure 2 below, more often than not, oil prices tend to be the leading indicator (as with USD/CAD) for CAD/JPY price action with a noticeable delay. As oil prices continued to rally, CAD/JPY easily broke the $100 level to hit a high of $105 before reversing. The "Oil vs CAD/JPY" chart also clearly shows the delayed reversal in CAD/JPY - which would have been a perfect trading opportunity.

Figure 2 - A look at the correlation between the price of oil and the price action in the CAD/JPY from December 2002 to September 2005

Going for Gold
Gold traders may also be surprised to hear that trading the Australian dollar is just like trading gold. As the world's third largest producer of gold, the Australian dollar has an 85% positive correlation with the precious metal. Generally speaking, this means that when gold prices rise, the Australian dollar appreciates as well. The proximity of New Zealand to Australia makes Australia a preferred destination for exporting New Zealand goods. Therefore, the health of New Zealand's economy is closely tied to the health of the Australian economy, which explains why the NZD/USD and the AUD/USD have had a 96% positive correlation over the past three years (2003-2005). Interestingly enough, the NZD/USD actually has an even stronger correlation with gold than the AUD/USD does - the correlation has been 90% over the past three years.

Figure 3 - A look at the correlation between the price of gold and the price action in the NZD/USD from December 2002 to September 2005

A weaker, but still important, correlation is that of gold prices and the Swiss franc. The country's political neutrality and the fact that its currency used to be backed by gold have made the franc the currency of choice in times of political uncertainty. From December 2002 until September 2005, USD/CHF and gold prices had an 85% positive correlation. However, the relationship broke down somewhat in September 2005 as the U.S. dollar decoupled from gold price movements. (For further reading, see The Gold Standard Revisited and What Is Wrong With Gold?)





Trading Currencies as a Supplement to Trading Oil or Gold
For seasoned commodity traders, it may also be worthwhile to look at trading currencies as an alternative or a supplement to trading commodities. In addition to being able to capitalize on a similar outlook (e.g. higher oil), traders may also be able to earn interest if they are on 2% margin or higher. When trading currencies, you are dealing with countries, and countries have interest rates, of course. For example, in the CAD/JPY trade, a trader who was long CAD/JPY would be able not only to make nice gains, but also to earn up to 3% in interest income. The rough estimate of 3% comes from taking Canada's central bank rate, which is the amount earned, and subtracting the 0% rates paid for shorting the Japanese yen. These are un-leveraged rates, which means that with 10 times leverage, for example, net of any exchange rate changes, the interest income would be that much higher. Leverage also makes the trade riskier, which is certainly something to keep in mind when trading FX.

Along the same lines, if you shorted CAD/JPY to express a short oil view, you would end up paying interest. If you're a commodity trader looking for a bit of a change from the usual pro gold trade (for example), commodity currencies such as the AUD/USD and NZD/USD provide good opportunities worth looking into.

Conclusion
If you want to trade commodity currencies, the best way to use commodity prices in your trading is to always keep one eye on movements in the oil or gold market and the other eye on the currency market, watching how quickly it responds. Due to the slightly delayed impact of these movements on the currency market, there is generally an opportunity to overlay a broader movement that is happening in the commodity market to that of the currency market. Bottom line, it never hurts to be more informed about commodity prices and how they drive currency movements.

by Kathy Lien (Contact Author | Biography)

Kathy Lien is an internationally published author and the director of currency research at GFT. Her trading books include: "Day Trading the Currency Market: Technical and Fundamental Strategies to Profit form Market Swings" (2005), "High Probability Trading Setups for the Currency Market" E-Book (2006) and "Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game" (2007). Lien also runs an FX Signal Service, BKForex Advisor, with Boris Schlossberg - one of the few investment advisory letters focusing strictly on the 2 trillion/day FX market.