Trading commodities and currency correlations in the forex market is a very common approach. Australia (AUD) is one of the most significant producers of gold in the world, so the price of gold influences its economy and the amount available for export. Similarly, New Zealand (NZD) has a close relationship with Australia (AUD) in the sense that they are significant trading partners and are therefore at the mercy of fluctuations in Australia's economy.
In 2008, Australia was the fourth-biggest gold producer in the world, while the US was the third top buyer of gold in the world. This means the NZD/USD and AUD/USD are ideal currency pairs for trading with gold. Australia didn't export oil in 2009, yet in 2010, the AUD/USD was still positive in correlation to oil prices before diverging.
Another example is the export of oil from Canada. The Canadian dollar (CAD) strongly correlates with oil prices, while Japan (JPY), a significant importer of oil, is highly susceptible to oil prices.
If traders plan to make a considerable profit from commodities regardless of the correlations, they must time the correlation trade appropriately; at times, the relationship may dissipate, and such situations can be costly for those who misunderstand what is occurring.
Traders should be aware of the correlation by monitoring and timing it as it’s crucial to their success based on the market analysis presumed by weighing commodity and currency relationships.
Decide which currency and commodity relationships to trade
Not all currency and commodity correlations are worth trading. Traders have to consider additional fees, liquidity, access to reliable information, spreads, and commissions to identify pairs and commodities to trade based on the availability of data.
Liquidity and smaller spreads should be looked out for when trading commodities and currency correlations.
For example, Canada is a significant exporter of oil, and its economy is affected by the price of oil. Similarly, Japan, a significant importer of oil, has its economy affected by the price of oil as well. Due to the substantial effect that the price of oil has on Japan and Canada, the CAD/JPY pair is in a positive correlation with the price of oil.
Traders can monitor the USD/CAD pair because the price label of oil is in US dollars in most parts of the world. The disadvantage of trading the CAD/JPY with oil is that it’s less liquid and has large spreads when compared to USD/CAD. For that reason, traders should watch the USD/CAD as both countries are large importers and exporters of oil.
Another critical factor in these relationships involves looking for significant producers of any export and major importers of the same commodity. Then, check the currency cross to identify the currency correlation with the data. Traders looking to profit from these relationships would have to follow specific steps in identifying and trading the instruments successfully.
Chart showing correlation between XAU/USD and USD/JPY
Decide which instrument to trade
After traders discover which currency and commodity pairs have strong relationships, they need to decide on the particular currency pair to place their trades, or they can choose to trade both the commodity and the currency.
However, the decision depends on diverse factors like the availability of a given market and fees.
Monitor the relationships for “breaks”
Traders need to keep in mind that there is usually a correlation between a commodity and currency pair. It is necessary to monitor the relationship for a high correlation potential, but there are times when the strong correlation may reverse for some time or cease to exist.
The commodity and currency pair that correlated positively for a year may have negatively correlated or diverged in the following year, so traders should be aware of when a correlation is positively and negatively strong.
There are tools embedded in most modern trading platforms that help in monitoring correlations between commodities and currencies. For example, a correlation indicator can show a real-time relationship between a commodity and a currency pair over a given period.
Chart showing correlation between AUD/USD and XAU/USD
Time the commodity/currency trade
It's also important to know the best time to take a trade to avoid the fluctuating correlations between commodities and currencies. Traders should be aware of several factors when entering and exiting correlation trades. It’s important to ask questions such as:
- Is there a relationship between the commodity and currency, and for how long?
- Is one asset leading the other?
- Is the price diverging?
Also, traders should make use of a trend confirmation tool. If any divergence happens, they should wait for a reversal or trend where both the commodity and currency move in a correlated style.
The bottom line
Trading currencies and commodities correlations is not absolute. There are times when the relationship between both instruments breaks for an extended period. Therefore, traders need to be alert and check for correlation opportunities.
There are two ways traders can remain on top of recent information on both the currency and commodity: through correlation indicators or by monitoring the charts manually.