Chapter 21
Fundamental Trading Strategy: Commodity Prices as a Leading Indicator

Commodities like gold and oil have an important connection to the FX market. Understanding the nature of these relationship can help traders gauge risk, forecast price changes, and understand exposure. Even if commodities are unfamiliar, they will often move on the same fundamental factors as currencies, particularly when it comes to popular instruments such as gold and oil. As discussed previously, there are four major currencies that are considered commodity currencies: the Australian dollar, the Canadian dollar, the New Zealand dollar, and the Swiss franc. However, every one of these currencies is different, as are their correlation with commodities. Take the Canadian dollar, for example; it tends to move in line with oil prices, but the connection is complicated and fickle. There are different reasons for why these currencies mirror commodity prices in their movements; and knowledge of the fundamental drivers behind these movements, their direction, and the strength of their correlation can be an effective way to discover trends in both markets.

Let's start with gold and oil because they have the largest influence on currencies.

Gold

Before looking at the relationship that gold has with commodity currencies, it is important to understand the connection between gold and the U.S. dollar. The United States is the world's second largest producer of gold (behind South Africa), but a rally in gold prices does not always lead to dollar appreciation. Actually, when the dollar falls, gold prices tend to rise, and vice versa. This seemingly illogical occurrence is a byproduct of the perception investor's hold for gold. During periods of geopolitical instability, traders tend to shy away from the dollar and turn to the safety of gold. In fact, many traders coin gold as the anti-dollar. Therefore, if the dollar depreciates, gold gets pushed up as wary investors flock from the declining greenback to the steady commodity. AUDUSD mirrors gold movements most closely.

Between June 2010 and June 2015, AUDUSD had a strong 0.83, or 83%, positive correlation with gold as shown in Figure 21.1; so when gold prices rise, the AUDUSD would generally appreciate as well. The relationship comes from the fact that Australia is the world's second largest producer of gold, exporting about $5 billion worth of the precious metal annually. Because of this, the currency pair amplifies the affects of gold prices twofold. If instability is causing an increase in prices, this probably signals that the USD has already began to depreciate. The AUDUSD pair will then be pushed down further as importers of gold demand more of Australia's currency to cover higher costs. Surprisingly enough the CADUSD also had a 0.67 correlation with gold during the same period because Canada is the world's fifth largest producer of gold and a risk currency. Thus, rising gold prices could be a precursor to gains in AUD and sometimes even in the CAD.

Figure 21.1 AUDUSD and Gold

Source: eSignal

In the past, there was a strong correlation between the Swiss franc and gold because their reserves were backed by gold; but when the central bank abandoned the gold standard, this relationship broke. Between 2010 and 2015, gold and CHFUSD only had a 0.36, or 36%, positive correlation. Not everyone realizes how much the relationship deteriorated because many still remember the days when both were perceived as safe havens. The Swiss National Bank's 1.20 EURCHF peg also eroded the correlation between gold and the Swissie and it may be some time before this correlation returns.

Oil

Oil prices have a huge impact on the global economy, affecting both consumers and producers. The correlation between this commodity and currencies is far more complex and less stable than gold. In fact, of all of the commodity currencies, only one (the CAD) has any meaningful connection with oil prices.

The Canadian dollar is traditionally quoted as USDCAD but to examine the correlation between the Canadian dollar and oil, we find it more valuable to invert the pair and talk about CADUSD. The correlation index between oil and CADUSD is 0.67. The relationship has been stronger in the past but in recent years, the performance of the U.S. economy also played a role in the market's appetite for U.S. dollars. On a day-to-day basis, oil may not have a significant impact on the CAD, but over the medium term, as shown in Figure 21.2, the relationship can be strong, with oil acting as a leading indicator for the Canadian dollar. Canada is the world's fifth largest producer of oil, so the price of oil can have a significant impact on the country's economy.

Figure 21.2 CADUSD and Oil

Source: eSignal

The price of oil also impacts global inflation. In 2014, oil prices dropped from a high of $107 a barrel to $50 a barrel. This move caused inflation to fall across the globe, prompting easing measures by major central banks and forcing the European Central Bank to introduce quantitative easing in 2015. If oil prices decline in a meaningful way, it generally leads to more expansionary monetary policies, especially if it is driven by weaker growth and not offset by stronger demand. In contrast, rising oil prices can create inflationary pressures, leading to tighter monetary policy conditions. Therefore, the path of oil prices has implications for not only the CAD but all major and minor currencies.

Iron Ore and Dairy Prices

Iron ore and dairy prices can also influence the price action of commodity currencies. Iron ore is Australia's most important export, which means that a rise in iron ore prices will boost corporate profits and, in turn, the Australian dollar. Meanwhile, a decline in iron ore prices will hurt the currency. Dairy prices can influence the performance of the New Zealand dollar, because milk is the country's number one export.

Trading Opportunity

Now that the relationships have been explained, there are two ways to exploit this knowledge. Taking a look at Figures 21.1 and 21.2, you can see that commodity prices are generally a leading indicator for currency prices. As such, commodity bloc traders should monitor gold and oil prices to help determine where these currencies are headed. The second way to exploit this knowledge is to trade the same view using different products, which helps to diversify risk even when the high correlation. In fact, there is one key advantage of expressing a gold/oil view in currencies over commodities, and that is the opportunity to earn interest on the positions, which is something trading gold or oil futures do not offer.