Currencies and commodities are one of the items that fuel the trading world. Traders usually indulge in several currencies on the FX scene as well as a wealth of products on the commodities market.
Even so, other market participants branch from the traditional path of trading a sole option and combine the two trading instruments in a correlation trade. So how does one get about trading these combinations?
First off, you need a thorough understanding of each trading instrument and in this case, both the forex world as well as commodities. Additionally, get an understanding of the commodity correlations more so concerning the FX arena.
This article will seek to educate you on the facets surrounding commodity correlations. Further on, you will be able to gain crucial insight into the world of trading commodity and currency correlations.
Commodity Trading
First off, commodity trading involves the buying and selling of commodities. Commodities, unlike stocks, futures, currencies, and other trading instruments, are tangible.
You can grab a sack full of grain, or a barrel of oil etc. not that you would actually buy with a view of doing so, but rather these commodities have a physical aspect about them. On the other hand, a lot of forex and stock trading goes on online and are merely represented by numbers.
Across major global markets, commodities represent a critical aspect of these economies. Commodities, in the basic sense, drive the economy of a country through exports. Also, a lot of these commodities are essential to the daily lives of the citizens in any country.
Popular commodities in the US, for example, include oil, beef, grain and natural gas. All of these items are generally processed into finished products which then get into the economy for use by the citizenry.
When it comes to investing, commodities offer a means of diversifying one’s portfolio. Back then, trading commodities was a bit of work. It was thus a mainstay of seasoned traders because it demanded lots of time, money, and expertise to actualize.
However, things are much more seamless especially with the advent of computers. There are significantly more options for getting into the commodities market as opposed to yesteryears.
Common Commodities Being Traded Today
Commodities’ trading can be traced to the dawn of numerous civilizations. In fact, many great empires flourished on trading commodities such as grain, rubber, tobacco, tea, etc.
Many great empires arose and thrived because of their ability to trade large volumes of goods around the world. The British Empire, for instance, advanced their naval fleet and conquered the world through inter-continental trade.
What is interesting is that a lot of the commodities traded in previous years are still going strong up to this day. Moreover, the trade of agricultural-based products continues today and the US is a significant exporter of various grains such as wheat, soybean and corn.
Commodities’ trading today is sub-divided into four major categories as follows:
1. Energy
These include crude oil as the primary energy commodity, natural gas and coal which round up energy commodities. Energy drives economic giants and hence, some countries wholly rely on it for income. Such net exporters of crude oil like Canada peg their currencies on the commodity and when global prices dwindle, their currency similarly takes a hit.
2. Metal
Hard minerals make up metal commodities traded across the globe today. These include gold, copper, silver and iron. Metals are seen as a secure investment and during periods when market volatility is high, a lot of investors participate in gold trade. The value of gold has always been high over the years and in addition to being a tangible item, price fluctuations are rare.
3. Livestock and meat
Countries whose economies are built around agriculture mainly supply the market with produce from their countries. Live animals and their related products make up livestock commodities.
4. Agricultural commodities
These include grains such as rice, maize, soybean, wheat, and other crops like cotton and coffee. Additionally, processed agricultural items are also included in this segment such as sugar.
Commodity Prices And Currencies
Commodities fuel trade around the world and, as such, are an essential part of the greater trading scheme. The commodities market impacts various markets globally and in the case of FX, can determine the economic health of a country.
Forex traders are often aware of the different factors that affect currency values. The economic situation in any country has a direct impact on the worth of its currency globally and further affects how traders interact with a specific currency.
Countries whose exports mainly comprise of various commodities have the value of their currencies tied to their exports. As exports generally lend the economy a degree of vigor, so does their currency’s value ride on their exports.
Investors can then capitalize on this relationship to seek promising returns from the commodity currency correlation.
Determining Which Commodity And Currency Correlation To Trade
When considering which commodity and currency combination to focus on, take into account the economic strength as well as stability of the nation. Therefore, it would be wise to settle on major economies, especially leading exporters of specific commodities.
That said, there are three countries whose currency correlation to commodities is highest. They are Australia, New Zealand, and Canada. The Japanese and Swiss currencies also show a level of correlation with commodities but at a much-diminished level.
· Crude oil
Crude oil is today, at the center of pretty much the entire globe’s energy needs. Once refined into petroleum, crude oil is used in numerous sectors of the economy and without it, the massive industrialization witnessed in recent years would not have been.
This is how much the world depends on crude oil, a commodity that Canada holds the third largest reserve in the world. Needless to say, trading the CAD vis a vis crude oil is a solid choice.
Therefore, consider Canada’s export destinations such as the US. Currently, a large chunk of Canadian oil ends up on US shores. So any changes in demand for oil in the US will significantly affect the USD/CAD pair.
On this chart, you can see how the price of oil impacts the USD/CAD line.
Usually, the US demand for oil drives Canadian exports. So when the US isn’t buying oil from Canada, the CAD is also affected and further on the USD/CAD. These two have a negative correlation, and a stable oil figure in the global markets will cause a drop in USD/CAD and vice versa.
· Gold
Australia is the world’s second-largest gold producer globally and it only follows that the AUD correlates highly with this valuable mineral. An increase in the value of gold similarly causes the AUD’s worth to go up. Moreover, this has a positive effect on neighboring New Zealand, whose exports primarily end up in Australia.
Because of their shared relationship, the NZD/USD and AUD/USD also bear a high positive connection to each other.
· Iron ore
Another Australian leading export, iron ore, is closely tied to the value of AUD. China imports iron and steel to use in its extensive industrial projects. So if the demand from china drops, so too will the need for AUD. The value of the Aussie dollar will eventually take a hit.
Other global currencies linked to commodities include the following:
· Russian ruble
Russia is also a leading producer of oil and natural gas. Both the ruble and the price of crude move simultaneously. The recent global decline in demand for oil witnessed record lows in the energy sector. The ruble especially hit new lows on the worldwide scene forcing Moscow to deploy countermeasures.
· Peruvian sol
Copper makes up Peru’s primary export earner and the South American nation holds the second-largest reserves globally. At the moment, the demand for the metal in manufacturing industries has been on a steady decline following the recent global pandemic. As more countries worldwide are imposing restrictions on movement and economic activity, the future of copper is bleak.
In the same vein, the Peruvian sol is set to take a dive following the inevitable situation with this striking red metal.
Time Your Commodity And Currency Correlation Trades
Both commodities and currencies experience fluctuating prices mainly as a result of the forces of demand and supply. As a result, you need to navigate these fluctuations carefully.
To do so, check the prevailing trend first. Use trend indicators such as MACD. Watch for any divergence or reversal. In the latter, hold out until a pattern develops whereby both currency and commodity lines exhibit correlation.
In a nutshell, the relationship between commodities and the forex trading scene spans several decades. These correlations have been studied throughout the time and point to a reliable trading option. However, markets shift, and trends change necessitating a similar change in these correlations.
For investors, such correlations offer a different perspective of the FX market and can lead one to various trading opportunities. Using indicators and charts, traders can monitor how the commodities and currency interact and identify the best points to enter a trade.
However, as mentioned before, a lot can change in the global market, and this can significantly affect the interplay between currency and commodities. It is always prudent to be on the lookout.