Thursday, July 23, 2009

Use Commodity Prices as Leading Indicators in Currency Trading

By Ahmad Hassam

Commodities, namely gold and oil, have a strong and substantial correlation with forex markets. By understanding this relationship between gold, oil and currency pairs, you as a forex trader can gauge risk, forecast price changes as well as understand exposure.

Gold and oil essentially tend to move based on almost similar fundamental factors that affect currency markets. Four major currencies, the Australian Dollar, the New Zealand Dollar, the Canadian Dollar and the Swiss Franc are considered to be commodity currencies.

The AUD, NZD, CAD and CHF all have strong correlation with the gold prices. Natural gold reserves and currency laws in these countries result in almost mirror like movements. The CAD also tends to move somewhat with the oil prices.

However, the correlation is not that strong. Each one of these currencies has a correlation with gold and oil and the fundamental reasons of doing so.

Knowledge of the fundamental reasons behind these correlated movements between gold, oil and these currencies and their direction and strength could be a good method to discover trends in both the markets. There is a strong correlation between gold prices and US Dollar too.

During times of geopolitical instability as well as when fears of global recession become strong, traders tend to shy away from Dollar and instead turn to gold as a safe haven for their investments.

Therefore, as Dollar depreciates, gold prices tend to appreciate as wary investors become afraid of losing their wealth. AUD/USD, NZD/USD and USD/CHF currency pairs tend to mirror gold movements.

Oil prices normally tend to have a huge impact on the global economy. Remember, the early part of 2008 when oil and commodity prices jumped skyward making the global economy jittery. Oil prices have come down but it is being forecasted that it will rise again when the global economy comes out of recession and the demand for oil rises again. USD/CAD currency pair tends to show an oil relationship. The major reason for this relationship is the heavy dependence of foreign oil in both US and Canada.

Generally speaking, commodity prices are usually considered to be a leading indicator of currency prices. As such, commodity block traders monitor gold and oil prices to forecast movements in currency pairs. The knowledge of this relationship between gold, oil and currencies can help forex traders to diversity their risk exposure using different products. The combination of gold and forex trading can be very profitable.

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