The correlation between Forex markets and commodities

The US dollar and gold don’t get along very well in the forex markets. The empirical evidence shows that when the first goes up, the second goes down. And viceversa. The economic explanation for this trade-off is that, during negative economic cycles, traders sell dollars and buy gold, since they consider it a safe haven. As we know, currency prices depend on many factors, including money supply, interest rate decisions, speculation and macroeconomic data. Since economic growth and trade are directly related to the performance of a country’s domestic industry, some currencies are strongly correlated to the prices of commodities produced in the countries where they are issued.

Austrialia, Canada and Russia are examples of currencies linked to commodities. For example, Australia is currently the third largest gold producer in the world. This is why the gold price and the AUDUSD (Aussie) pair are strongly correlated. This stable relationship holds over time. Gold has a positive correlation with the Aussie. When it goes up, the Aussie goes up. And viceversa. Historical data show that the Aussie had an 80.0% correlation with the price of gold, a really high value.

This strong correlation creates for traders the opportunity to follow a pair trading strategy, based on the simultaneous purchase and sale of two related activities. A pair trading strategy reduces part of the directional market risk. Pair trading extends the length of time and reduces commercial risk, although this does not necessarily mean the guarantee of higher profits. If the relationship breaks down, trading opportunities may arise. If the correlation decreases because the gold price goes up and the Aussie does not do the same, the pair trading strategy offers profit opportunities. This divergence can be exploited by going short on gold (the strongest instrument) and simultaneously going long on Aussie. Once both the value of gold and that of the Aussie return to the statistical average, a profit is made.

In the long term, the Aussie follows price patterns similar to those of gold. Many traders prefer to go long on Aussie rather than buy gold contracts directly, for the simple reason that gold does not offer any interest rates. Furthermore, if a trader goes long with a gold contract, he is forced to pay an overnight rate (negative swap value). On the contrary, the Aussie offers a positive swap value which means that it pays the trader an overnight rate. For long term trading this can be an advantage.

The Australian dollar has other correlations. For example, in the past two decades, the correlation with copper has been over 70.0%. The Aussie is also correlated to silver and other commodities and strongly correlated to the New Zealand Dollar, by more than 90.0%.

Also the Swiss franc (CHF) has a strong link with gold. The reason why it moves hand in hand with it is because more than 25% of Switzerland’s money is guaranteed by gold reserves. So when gold goes up, the CHF goes up too. And viceversa.

Oil is another fundamental commodities for the global economy. Even today, most people in developed countries cannot live without oil. As a net exporter, Canada is strongly affected by the trend in oil prices, while Japan is a major net oil importer which benefits from falling prices. Therefore, the fluctuation in oil prices has an impact on both the CAD and the JPY. When oil rises, the CAD rises and the YEN falls. And viceversa.

The relationship between gold, oil and major currencies can help traders to trade with different strategies or hedge their portfolios. The slightly delayed correlations of these movements on the currency and commodities markets sometimes offer operators good opportunities to anticipate a larger movement.

Compared to Canada and Australia, Russia’s export mix is ​​not as diverse: about half of Russian exports are made up only of oil and natural gas. Russia enjoys the third largest oil reserve in the world and the main natural gas reserves. Therefore, it is not surprising that the ruble is heavily influenced by the price of crude oil. When oil dropped sharply in July 2014, the ruble also dropped heavily. However, the correlation between the ruble and crude oil shrank in early 2018, when the United States imposed sanctions against Moscow for its alleged interference in the 2016 U.S. presidential election.

Brent is the oil extracted from the North Sea and is therefore mainly traded in Europe. Several countries have access to Brent, but Norway is estimated to hold around 54% of the North Sea’s oil reserves, so its currency, the Norwegian krone, is heavily influenced by Brent price. Norway is the fifth largest oil exporter and the third largest gas exporter with domestic industries representing more than 20.0% of Norwegian GDP.

While the correlations we have seen are the best known and most reliable, there are many other commodities that influence currencies. According to some estimates, known oil reserves will only supply the world until around 2040, after which we will have to find another source. Some believe that Bolivia will be the next Saudi Arabia due to its vast lithium reserves, a fundamental component for the production of electric car batteries. It is good a trader always keeps up to date on what commodities trend may be, when he wants to trade with particular currencies.

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