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Correlating commodities and forex

Trading in commodities can be confusing for new traders. Frequently, individual contracts are worth different amounts per index point movement, they each have their own margin requirements, and spreads can vary enormously.

However, traders can cash in on the changing prices of commodities by trading the currencies with which they correlate. This is frequently the case concerning the currencies of major producers or buyers of certain commodities.

GoldForex

South Africa, Australia and the USA are three of the top five gold producers globally, and each of their currencies has traditionally had a strong correlation with the yellow metal.

As a commodity currency, the Australian dollar has a strong positive correlation with several commodities and, typically, when commodity prices go up, so does the Aussie dollar. This can be seen in respect to recent US dollar weakness – as most commodities are priced in USD, commodity prices rise when the USD falls, meaning that the AUD has also risen in response.

From 2002 to 2005 the AUD served as a proxy for gold and had a 96% degree of correlation with the US gold price. Despite the relationship weakening since then, the AUD had an 80% degree of correlation with gold in the decade to 2010, meaning that the USD price of gold and the AUD/USD trend in the same direction 80% of the time.

In the case of the South African Rand, a strong price trend in gold is reflected in the currency. From April 2009 to June 2010, gold prices soared from USD863 an ounce to USD1,233.25 an ounce, which was mirrored by a rally in the ZAR. Although the 24% climb in the ZAR wasn’t quite as enthusiastic as gold’s 43% surge, the ZAR did break technical support against the USD.

In contrast, the USD has a strong negative correlation with the precious metal – typically trending in the opposite direction. As with other commodities, because gold is denominated in US dollars, USD weakness is reflected in gold price strength. However, this breaks down during economic strife, as both the USD and gold are seen as safe havens (although, when that strife concerns the US, gold becomes the haven of choice).

Silver

Mexico is the world’s top silver producer, resulting in the Mexican peso having a strong positive correlation with silver. At the start of the second quarter of 2009, silver prices were trading at USD12 per troy ounce, while the Mexican peso was trading at 14 pesos per US dollar. Silver prices reached USD19.45 in December, while the peso rose by 10.4% against the USD. In contrast, other major currencies only appreciated by half that amount against the USD over the same period.

A trader wanting to take advantage of silver’s rise could have done so by trading long on the Mexican peso.

Copper

Unlike the previous precious metals, copper is used in the production of electrical and manufacturing products, meaning that there will always be a consistent demand for the red metal.

Chile is the world’s largest copper producer, having produced nearly 5.5 billion tonnes in 2009 (the world’s second largest producer, the US, only produced 1.3 billion tonnes) and capturing nearly a third of the global copper market.

Consequently, the Chilean peso and the price of copper have a strong positive correlation. Between February and October 2010, the price of copper futures rose by 32% to USD3.80 per pound. Over the same period, the Chilean peso rose 11% against the US dollar.

Australia is the fifth largest producer of copper globally, and the relationship between the AUD and the red metal is even stronger than its correlation with gold. In the decade to 2010 the AUD had 80% degree of correlation with the price of gold. Over the same period, the currency had a 93% degree of correlation with copper.

How to profit

Traders can use technical indicators against commodity prices to determine the direction in which the price will trend, and when this trend will change. By predicting commodity prices, traders can develop a trading strategy to successfully trade on the currencies with which they correlate.

This article was written by Jacqueline Pretty – IG Markets. No representation or warranty is given as to the accuracy or completeness of the above information, consequently any person acting on it does so entirely at his or her own risk. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.

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