Understanding and measuring the relative roles of different causal channels between commodity prices and exchange rates has important implications in financial decision making, especially for market participants with short horizons. From a macroeconomic perspective, this can also be useful for interpreting exchange rate movements, financial market monitoring, and monetary policy. Basic economic reasoning on currency demand suggests that currencies of countries whose exports depends heavily on a particular commodity should strongly be influenced by its price, so commodity price movements should lead exchange rate movements.
Predicting the next move in the markets is the key to making money in trading, but putting this simple concept into action is much harder than it sounds. Professional forex traders have long known that trading currencies require looking beyond the world of forex. The fact is that currencies are moved by many factors - supply and demand, politics, interest rates, economic growth, and so on. More specifically, since economic growth and exports are directly related to a country's domestic industry, it is natural for some currencies to be heavily correlated with commodity prices.
It is widely known that exchange rate fluctuations of net commodity-exporting countries are correlated with commodity price movements. This was manifested most recently during the second half of 2014 when the currencies of many net commodity exporters, including the Canadian dollar (CAD), experienced sizable depreciation against the U.S. dollar (USD) as oil prices collapsed sharply. A recent paper by Ferraro et al. (2015) reported that oil prices have a strong predictive ability in explaining the movements of the CAD-USD exchange rate at the daily frequency, but the predictive ability diminishes at the monthly and quarterly frequencies.
Commodity currency’s exchange rates have surprisingly robust power in predicting global commodity prices, both in-sample and out-of-sample, and against a variety of alternative benchmarks. This result is of particular interest to policymakers, given the lack of deep forward markets in many individual commodities, and broad aggregate commodity indices in particular. For seasoned commodity traders, it may also be worthwhile to look at trading currencies as an alternative or a supplement to trading commodities. In addition to being able to capitalize on a similar outlook (e.g. higher oil), traders may also be able to earn interest if they are on 2% margin or higher with most brokers.
If you want to trade commodity currencies, the best way to use commodity prices in your trading is to always keep one eye on movements in the oil or gold market and the other eye on the currency market to watch how quickly it responds. Due to the slightly delayed impact of these movements on the currency market, there is generally an opportunity to overlay a broader movement that is happening in the commodity market to that of the currency market. Bottom line: It never hurts to be more informed about commodity prices and how they drive currency movements.
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