When the domestic economy is greatly affected by commodity price shifts, then the currency is especially vulnerable. Commodity price shifts will not affect all nations, or their currencies, in the same manner. After all, nations with moderate supplies of a commodity will not have their currency affected as greatly by price shifts as nations who have little to no supply of their own. In the same vein, for example, nations who have vast oil supplies and who therefore have a significant portion of their economies tied to crude prices will see strong correlations between commodity prices and their currency exchange rate.
Professional forex traders have long known that trading currencies require looking beyond the world of forex. Currencies are moved by many factors, including supply and demand, politics, interest rates, speculation, and economic growth. 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. The top three currencies that have the tightest correlations with commodities are the Australian dollar, the Canadian dollar, and the New Zealand dollar.
Canada, one of the top oil producers in the world, exports over 3 million barrels of oil and petroleum products per day to the United States. This makes it the largest supplier of oil to the US! Because of the volume involved, it creates a huge amount of demand for Canadian dollars. Knowing that Canada’s economy is dependent on exports, with about 85% of its exports going to its big brother down south, the US Because of this, USD/CAD can be greatly affected by how US consumers react to changes in oil prices. If US demand rises, manufacturers will need to order more oil to keep up with demand. This can lead to a rise in oil prices, which might lead to a fall in USD/CAD.
When a country’s principal export is oil or a commodity, its currency exchange rate tends to track the global price of that export. When the price rises, so do the exchange rate. The rising global price tends to attract inward investment and resources to the extractive industry, while other export industries struggle due to the high exchange rate – a phenomenon known as “Dutch disease”, in which the economy becomes increasingly dependent on its extractive industries. When the prices of oil and commodities fall, the currency exchange rates of exporting countries fall in tandem. Currencies that naturally track oil and commodity prices are known as “commodity currencies”.
Australia (AUD) and New Zealand (NZD) have a close relationship to gold prices and oil prices. While the correlations (positive or negative) can be significant, if forex traders want to profit from them, it's important to time a "correlation trade" properly. There will be times when a relationship breaks down, and such times can be very costly for a trader who does not understand what is occurring. Being aware of a correlation, monitoring it and timing it is crucial to successful trading based on the inter-market analysis provided by examining currency and commodity relationships.
Compared to Canada and Australia, Russia’s export mix isn’t nearly as diversified: about half of its exports in terms of value are a combination of oil and natural gas. (Russia sits atop the third-largest oil reserves in the world and the number one natural gas reserves.) It should come as no surprise, then, that its currency is highly influenced by the price of crude. When oil fell in July 2014, so did the ruble. However, the ruble and crude decoupled in early 2018 when the U.S. imposed sanctions against the Eastern European country for its alleged meddling in the 2016 presidential election.
For Japan (JPY), the situation is completely reverse because Japan must import oil to meet its vast energy needs. Simply stated, any time a nation must spend more to purchase its energy, the less money is left over for domestic spending and investment. Therefore, the currency will weaken in a modern economy that is heavily dependent upon oil imports when crude prices surge - as they did in 2005. The more dependent the nation is upon foreign oil and the greater the role that oil plays in the overall economy, the more currency rates will be affected by oil prices. Japan imports 99% of its oil and also imports large percentages of its natural gas and other energy sources. Basically, its currency takes a beating when oil prices surge.
In the short run, higher commodity prices lead to an increased supply of foreign exchange in the markets of commodity exporters, as a result of increased export revenues—causing an appreciation of the domestic currency. In the medium to long run, this effect might then be compounded by ensuring foreign direct investment, as a result of more attractive investment prospects in the local commodity sector. The above mechanisms tend to be fairly evident in the economies of commodity exporters. For such countries, the price variation of key export commodities is often seen as a reasonably good proxy for terms-of-trade movements. Hence, changes in the prices of key exports may well bear a close link with exchange rate movements.
A closer look at the issue of factors influencing price developments suggests again the old wisdom that the most important aim of a commodity policy remains diversification, not only into other commodities to reduce the immediate risk of price and export fluctuations but, above all, into semi-finished and finished products to counter the long-run decline in the relative importance of commodities in world markets. The role of exchange-rate policies with regard to export promotion in commodity-dependent countries has to be regarded with care. The worldwide tendency to oversupply on commodity markets, the not very elastic demand and the danger of outweighing movements on world currency markets diminish the value of the exchange rate as an effective policy tool.
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