Understanding Commodity Currencies

Understanding Commodity Currencies

The forex markets have many interesting features that might not be readily apparent when newer traders are starting to gain experience.  One such factor can be seen in the interrelated nature of asset prices across markets.  For example, there are some assets that share a high positive correlation with certain currencies that are traded in forex.  Specifically, this means that upward price changes in one asset will generate upward price changes in the other.  At the same time, situations where prices fall will likely lead to price declines in both of those assets.

When looking at specific currencies that experience this type of activity, it is important to note commodity currencies as these are tradable instruments that can be accurately assessed in terms of which direction markets are likely to head next.

Australian Dollar and Canadian Dollar

“If we are looking at which currencies to classify as commodity currencies, two of the first names that are likely to come up will be the Australian Dollar and the Canadian Dollar,” said Tony Davis, precious metals analyst at Atlanta Gold and Coin.  “This is largely because these currencies are closely associated with price moves in commodities like gold and oil.”  This is an important element for forex traders to remember because it is often possible to forecast the price direction of both the Australian and Canadian Dollars based on where commodities prices are headed.

For example, if we start to see gold prices rally it would be reasonable to expect bullish activity in the Canadian Dollar.  This is true because there are large gold deposits in Canada and the expectation is that Canada will benefit from higher export prices if the value of gold is rising.  This is a positive outlook for the Canadian Dollar as this is a central factor that the market uses to determine an appropriate value for the currency.  Similar factors are true for the Australian Dollar when the price of copper is seen rising.

Benefits of Commodity Currencies

The fact that commodity currencies exist is of great benefit for forex traders because it gives us another direction to look when we are trying to build a price forecast that can be used to establish a position.  For example, if we see rising gold prices it might be a good idea to start establishing short exposure in a currency pair like the USD/CAD.  Higher gold prices will create a positive outlook for the CAD and if the currency starts to gain in strength this would translate to a lower USD/CAD.  Conversely, higher copper prices would be beneficial to the AUD so it might then be a good idea to start looking at long positions in the AUD/USD.

Of course, prices in gold and copper will never find themselves in trends that are purely positive, so forex traders will also be able to bet against these currencies if commodities markets start to falter.  Using the examples above a negative outlook for commodities would likely generate more long positions in the USD/CAD and short positions in the AUD/USD.  So if traders are able to spot these trends before they occur, it will become entirely possible to establish moves in these currency pairs before any of the significant price moves exhaust themselves.  This creates the potential for significant profits to be made with relatively little fundamental analysis to be conducted.  Of course, there will always be other factors at work in the market which will ultimately determine where prices are likely to move — and by how far.  But having a firm understanding of how commodities markets can impact the forex space can be a highly beneficial piece of information that can alert traders to potential positions that might not otherwise be apparent.

 

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About the Author
Richard Cox is a university teacher in international trade and finance. Lessons in macroeconomics and price behavior in equity markets. Trade ideas are generally suggestive of time horizons of one to six months.

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