Correlations between commodities and currency pairs may seem daunting to the novice trader, but once the main idea behind them is grasped, they can become a powerful tool for effective trading. When commodities are traded between two nations, currencies also switch hands from the buyer to the seller, and the value of each country’s currency against the other can be affected by the value of the traded commodity. As commodities are usually sold in the currency of the exporting nation, the price of the commodity tends to correlate positively to the exporting/importing currency pair. It is important to note, however, that not all correlations are worth trading. The best ones are those that are already heavily traded, since more information about them is readily available, and they have a smaller spread and higher liquidity.
The Strongest Correlations
The strongest correlations between commodities and currencies are those relating to oil and gold.
Oil and USD/CAD: Canada is one of the world’s main exporters of oil and the U.S. one of the main importers. Since oil however, is always sold in USD, this particular correlation is noted in USD/CAD (and not in the expected CAD/USD pair) and thus its trend is a negative one: when the price of oil rises, the USD/CAD exchange rate falls.
Oil and CAD/JPY: Japan is another large importer of oil. With Canada supplying a big proportion of Japan’s oil needs, the price of oil has a tight, positive correlation to the value of the CAD/JPY pair: when the price of oil goes up, the currency pair also shows upward movement.
Gold and AUD/USD: One of the main exporters of gold to the world is Australia, while the U.S. is one of the main importers. The price of gold tends to correlate positively to the movements of the AUD/USD currency pair on the foreign exchange market: a rise in one usually signifies a rise in the other, and vice versa.
Correlations between commodities and currencies can signify important trading opportunities. A trader monitoring these correlations can choose to trade in commodities, in currency pairs, or in both, depending on the access one has to the market, and on one’s trading strategies (commodities tend to be more volatile than currency pairs). The savvy trader, moreover, understands that these correlations are not consistent at all times, but rather need to be closely monitored. While a correlation runs strong, a trader may wish to catch small divergences in the pattern for short-term trades. When, however, the strength of the correlation begins to weaken, the trader should curb his predictions, because the correlation may be entering a period of deterioration, leading to unpredictable results. Nevertheless, the return of a correlation to its regular pattern after a prolonged aberration can be a strong indicator of a starting trend that can be exploited in longer-term trades.