Relationship Between Commodities and Forex
When it comes to trading, there’s one of the most dynamic and interconnected markets. It’s the relationship between commodities and Forex. As an intermediate trader, understanding how these two asset classes influence each other is crucial.
This understanding lends weight to enhancing your trading strategies. In this guide, we will explore how commodities can affect currency markets. You’ll be shown simple examples and practical calculations to clarify the concepts.
What are Commodities?
Commodities are raw agricultural products that can be bought and sold. They are typically divided into two categories: hard commodities (like gold, oil, and natural gas) and soft commodities (like wheat, coffee, and sugar).
These products are traded on various exchanges around the world. Thus, they have a direct impact on economies and currencies.
The Basics of Forex Trading
Forex involves buying and selling currencies on the global market. The value of one currency relative to another fluctuates based on a variety of factors, including:
- Economic data,
- Interest rates,
- Geopolitical events, and of course,
- Commodity prices.
The forex market is the largest and most liquid financial market in the world. This market boasts itself with daily trading volumes exceeding $6 trillion.
The relationship between commodities and forex always arises. It’s because many countries’ currencies are closely linked to the value of the commodities they produce or consume.
This is particularly true for commodity-rich nations. This is where their currency value is often influenced by the prices of key commodities.
How Commodities and Forex are Connected
1. Currency pairs and commodity exports
Let’s start with a simple example. Suppose you’re trading the AUD/USD currency pair.
The Australian Dollar (AUD) is heavily influenced by the price of commodities, (particularly metals like gold and iron ore). Australia is a major exporter of these metals. So, when global demand for these commodities rises, the value of the AUD tends to appreciate.
Conversely, if commodity prices fall, the AUD may weaken.
For instance:
If the price of gold increases from $1,800 to $1,900 per ounce, this could lead to a strengthening of the AUD. It’s due to traders expect higher exports and a positive impact on Australia’s trade balance.
This, in turn, could push the AUD/USD exchange rate higher.
2. Commodity-driven inflation and central bank policies
Another key link between commodities and forex is inflation. Commodities like oil and gas play a vital role in the global economy. When the price of oil rises, it can lead to higher transportation and production costs, contributing to inflation.
Central banks, such as the U.S. Federal Reserve, closely monitor inflation and adjust interest rates accordingly.
If inflation rises due to a surge in oil prices, the central bank may increase interest rates to curb inflation. This could lead to a stronger currency because higher interest rates often attract foreign capital, boosting demand for the currency.
For example,:
If oil prices spike, and the Federal Reserve (Fed) raises rates to control inflation, the USD could appreciate against other currencies.
3. Risk sentiment and commodity prices
Traders’ attitudes towards risk can also affect the relationship between commodities and forex. In times of economic uncertainty, investors often seek safe-haven assets like gold.
It’s which is considered a store of value. As demand for gold increases, so does the demand for the currency of gold-producing nations, such as the Canadian Dollar (CAD).
In contrast, when risk appetite is high, traders may flock to riskier assets, such as stocks or higher-yielding currencies. This shift in risk sentiment can cause commodities like oil and metals to fall.
As a result, this impacts currencies that are sensitive to commodity prices.
Examples: How Commodities Influence Forex Pairs
Example 1: Oil and the Canadian Dollar (CAD)
Canada is a major oil producer. So, the value of the Canadian Dollar (CAD) is often linked to the price of oil.
For example:
If crude oil prices rise from $60 to $70 per barrel, the Canadian Dollar may strengthen against the U.S. Dollar (USD).
It’s because higher oil prices benefit Canada’s economy. Traders may buy the CAD in anticipation of stronger economic performance, which can push the USD/CAD pair lower.
Example 2: Gold and the Australian Dollar (AUD)
Australia is one of the world’s largest gold producers. Therefore, the price of gold has a direct impact on the value of the Australian Dollar.
If the price of gold rises from $1,200 to $1,300 per ounce, the Australian Dollar may appreciate relative to other currencies like the U.S. Dollar (USD). The reason is investors expect higher export revenues from gold.
Example 3: Wheat and the Russian Ruble (RUB)
Russia is a major producer and exporter of wheat. Of course, the price of wheat can significantly affect the Russian Ruble (RUB).
If wheat prices increase due to a global shortage or rising demand, Russia’s economy may benefit, leading to a stronger RUB. Conversely, if wheat prices fall, Russia’s economic outlook could weaken, and the RUB could depreciate.
How to Trade Commodities and Forex Together
As an intermediate trader, it’s essential to understand how to combine your knowledge of commodities with your forex trading strategy. Here are some tips:
- Monitor commodity price trends: Keep a close eye on the price movements of key commodities that impact the currencies you trade. This will help you anticipate potential currency fluctuations and make informed trading decisions.
- Use technical analysis: Use chart patterns and indicators like moving averages, RSI, and MACD to identify potential entry and exit points for both commodities and forex pairs.
- Consider geopolitical factors: Geopolitical events, such as conflicts in oil-producing regions or natural disasters affecting agricultural production, can have a significant impact on commodity prices and, by extension, the forex market.
- Diversify your trades: Consider trading a combination of commodities and forex pairs to hedge risk. For example, if you’re long on oil, you may want to go short on a currency pair like the USD/JPY, which tends to move in the opposite direction.
Conclusion
Understanding the relationship between commodities and forex is essential for intermediate traders looking to enhance their trading strategies.
By recognizing how commodities affect currency movements, traders can make more informed decisions in the forex market.
Remember to keep an eye on commodity prices, monitor central bank policies, and use both technical and fundamental analysis to guide your trades.