Forex Walkthrough

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Economics - Commodities

It is widely known that economic growth and exports are directly related to a country's domestic industry, so it is natural for some currencies to be heavily correlated with commodity prices. The three currencies with the tightest correlations to commodities are the Australian dollar, the Canadian dollar and the New Zealand dollar. Other currencies that are also impacted by commodity prices but have a weaker correlation are the Swiss franc and the Japanese yen. Knowing which currency is correlated to which commodity can help traders recognize and predict market movements. Here we will look at currencies correlated with oil and gold and show you how you can use this information in your trading. (For background reading, see The Most Popular Forex Currencies.)

Oil and the Canadian Dollar
Over the past few years, the price of commodities has fluctuated considerably. Oil, for example, surged from $60 a barrel in 2006 to a high of $147.27 a barrel in 2008 before plummeting back below $40 a barrel in the first quarter of 2009. Similar volatility has been seen in the price of gold. Knowing which currencies are affected by what commodities will help you make more educated trading decisions. (Find out how the everyday items you use can affect your investments in Commodities That Move The Markets.)

Oil is one of the world's basic necessities - at least for now, most people in developed countries cannot live without it. In February 2009, the price of oil was nearly 70% below its all-time high of $147.27 set on July 11, 2008. A drop in oil prices is every oil producer's nightmare, while oil consumers enjoy the benefits of greater purchasing power. This is a complete 180-degree change from the situation at the beginning of 2008, when record-high oil prices had oil producers doing back-flips while forcing consumers to pinch pennies. There are a number of reasons to explain the fall in oil prices, including a stronger dollar (since oil is priced in dollars) and weaker global demand. As a net oil exporter, Canada is severely hurt by declines in oil, while Japan - a major net oil importer - tends to benefit.

Between the years 2006-2009, for example, the correlation between the Canadian dollar and oil prices was roughly 80%. On a day-to-day basis, the correlation will often break, but over the long term it has been strong because the value of the Canadian dollar has good reason to be sensitive to the price of oil: Canada is the seventh-largest producer of crude oil in the world and 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. Most are unaware that 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 locales from which the U.S. imports oil. (Read more in Peak Oil: What To Do When The Wells Run Dry.)

Figure 1 shows the 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 of 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 and when oil prices go down, USD/CAD rises.



Figure 1: A look at the correlation between the price of oil and the price action in
the CAD/USD from January 2005 to March 2009
Source: FXCM


Oil and the Japanese Economy
At the other end of the scale is Japan, which imports almost all of its oil (compared to the U.S., which imports approximately 50%). As of 2009, it is the world's third-largest net oil importer behind the U.S. and China. Japan's lack of domestic sources of energy, and its need to import vast amounts of crude oil, natural gas and other energy resources, make it particularly susceptible to changes in oil prices. Therefore, when oil prices rise dramatically, the Japanese economy suffers. (Hedge against rising energy prices and diversify your portfolio; read ETFs Provide Easy Access To Energy Commodities.)
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 watch is the Canadian dollar against the Japanese yen. Figure 2 illustrates the tight correlation between oil prices and CAD/JPY. As with the USD/CAD, oil prices tend to be the leading indicator for CAD/JPY price action with a noticeable delay. As oil prices continued to fall during this period, CAD/JPY broke the 100 level to hit a low of 76.



Figure 2: A look at the correlation between the price of oil and the price action in the CAD/JPY from January 2005 to March 2009
Source: FXCM


Going for Gold
Gold traders may also be surprised to hear that trading the Australian dollar is just like trading gold in several ways. Australia is the world's third-largest producer of gold, and the Australian dollar had an 84% positive correlation with the precious metal between 1999 and 2008. 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 very 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 same time period. The correlation of the NZD/USD with gold is slightly less than that of the Australia dollar but it remained strong at 78%.



Figure 3: A look at the correlation between the price of gold and the price action in the NZD/USD from January 2005 to March 2009
Source: FXCM


A weaker, but still significant, correlation is that of gold prices and the Swiss franc. Switzerland'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 insecurity. From January 2006 until January 2009, USD/CHF and gold prices had a 77% 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 a substitute or a complement 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 with most brokers. When trading currencies, you are dealing with countries, and countries have interest rates, of course. For example, a trader who may have bought the AUD/USD in March 2009 would be able to earn up to 3% in interest income if Australian interest rates remained at 3.25% and U.S. interest rates remained at 0.25% for the entire year. These are unleveraged rates, which means that with 10 times leverage, for example, net of any exchange rate adjustments, the interest income would be that much higher. Leverage also makes the trade riskier, which means that if the trade turns against you, losses could add up.
Along the same lines, if you shorted AUD/USD to play a short gold 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 greatest 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 on the currency market to see 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 informed about commodity prices and how they drive currency movements. (For more insight, read The Currency Market Information Edge and Forex: Wading Into The Currency Market.)
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