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Understanding Commodity and Currency Correlations

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If you have been trading on commodities or currency prices for a little while, you will already be aware that some currencies on your spread betting or CFD trading platform are more responsive to commodities prices than others.

This is often because buyers of the raw materials that country produces will have to buy its currency first. A good example is the Australian Dollar (AUD), which enjoyed a solid growth trend while China was busy hoovering up Australian mineral resources to fuel its industrial expansion.

Commodity Currencies Research from Societe Generale

But recent research from French bank Societe Generale has shown that other currencies can also be impacted by commodity markets. While most traders will tend to focus on the major currency pairs, many brokers are now quoting prices for emerging markets currencies and there could be opportunity to profit from changes in commodity and currency trends in emerging markets this year.

The Chinese economy is slowing down, and with it the country’s demand for overseas commodities. New sources of oil and gas mean there will be less demand for these commodities in 2014. While OPEC can reduce flow to an extent, many analysts are now predicting downward pressure on energy markets. Coupled with this, US tapering and higher US bond yields as the economy recovers will add further downward pressure.

So which currencies should traders be looking at? SocGen’s cross asset research has produced the following table. We have edited it to just include the currencies that we know to be available via retail spread betting or CFD trading platforms, or via private margined forex accounts. Some emerging markets currencies are still not readily available from forex brokers, but the range is being constantly added to, so keep checking with your broker.

Which commodity drives Which commodity is driven by
Oil – Brent CAD, JPY, BRL, NOK
Oil – WTI CAD, BRL, NOK
Aluminium AUD
Coal AUD, ZAR, JPY
Wheat AUD, CAD
Platinum ZAR
Copper JPY

 

Currency against USD. Source: SG Cross Asset Research / Commodities

Most of the above commodity currencies are likely to see consistent selling pressures over at least the three month time horizon, if not longer. We appreciate, of course, that some currencies like the JPY should not be considered commodities currencies at all, but traders should not underestimate the importance of commodities trade flows to the currency markets.

The ZAR looks like it will bear further study in the near term. It is unlikely that South Africa’s central bank will intervene further in the currency markets until the autumn. The AUD, however, could develop some interesting trends as China’s economy continues to come off the boil and hot money flows into other assets in the USD market.

According to SocGen: “Two main uncertainties currently lie at the root of the [emerging markets] problems: country-specific risks and Fed forward guidance. Looking at the resulting effect of uncertainty on commodity markets through a recursive co-integration analysis, we can conclude that increased uncertainty causes commodity price changes and not the other way around.”

SocGen also observes that the negative correlation between the VIX index and commodity currencies has clearly dropped, although more so with G10 currencies than emerging markets. It argues that while gradually rising rates should be supportive of commodity markets, a spike in rates, i.e. sudden hiking of rates by central banks – could be damaging.

Much will depend on whether you are a trader who likes to profit from established price trends or prefer to capitalise on volatility. Certainly if we enter a steepening rate environment in the G10 countries, there could well be higher volatility in commodities prices. This will not be good news for trend followers or those using programs that rely on established trends (e.g. informed by commodities price action and correlations since the beginning of the China-driven global commodities boom).

What we have not mentioned here is the NZD, again easy to trade on retail platforms, and a currency issued by a country with major soft commodities exports (accounting for almost a third of the global dairy products trade alone). However, demand for milk and cheese aside, New Zealand also faces an increasing current account deficit. We are now in a less forgiving financial environment than the last time NZ was running up its current account deficit (2006-07) and any signs of increasing uncertainty regarding the Kiwi balance sheet will hit the NZD.

While some traders will continue to focus on purely currency markets and others will remain loyal to commodities, it does pay to occasionally do some inter-market commodity currencies analysis. Professional traders of, for example, the CAD, will constantly be keeping one eye on developments in the commodities cycle. Being aware of what is happening here does not mean that you have to open a trade in a commodity market, but you could use technical analysis to isolate developing trends in a particular commodity that is important for a specific country’s economy.

For further information on the science of intermarket analysis, it is worth looking at Ashraf Laidi’s Currency Trading and Intermarket Analysis, or go to his website – www.ashraflaidi.com

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Hargreaves Lansdown IG Interactive Brokers Interactive Investor Charles Stanley
IG Interactive Brokers Charles Stanley

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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