Currency Traders: All Eyes on Commodities

06/23/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

The Canadian, Australian, and New Zealand dollars were down sharply yesterday morning as signs of a top emerge in the commodity markets. Oil prices closed below $70 a barrel on Friday, and at the time of writing, are trading at $67.90. Gold prices are also down $14 to less than $920 per ounce. On an otherwise quiet trading day in the FX markets that is devoid of any US economic data, commodities are having a big impact on currencies.

On Friday, we showed the following chart of USD/CAD and oil. As you can see, the relationship is very strong with the correlation being close to 80% over the past two years.

Therefore, the 2% drop in oil prices this morning has driven the Canadian dollar sharply lower against the US dollar and Japanese yen, exacerbating the pessimistic tone that followed Friday's weak retail sales report. International securities transactions increased more than expected in April, but the uptick in foreign demand for Canadian dollar-denominated assets has not helped the loonie. Although USD/CAD is flirting with the 1.15 level, the more interesting move is in CAD/JPY, which has broken significant technical support this morning. CAD/JPY is now trading below trend line support, the 50-day SMA, and the 23.6% Fibonacci retracement of the year-to-date rally.


Click to Enlarge

Is the Dollar Driving Oil, or Vice Versa?

Some traders may argue that oil prices are selling off because the dollar is higher. We have written about this at length last month in our special report, titled Is Dollar Driving Oil or Vice Versa? The bottom line is that oil and the dollar have both a schizophrenic and symbiotic relationship.

Oil is priced in US dollars. According to OPEC, the relationship between oil prices and the dollar is almost mechanical. When the dollar falls in value, oil prices have to go up in dollar terms to stay constant in euro terms. Oil producers receive their oil revenues in US dollars and need to be compensated for the fluctuations of the greenback. This does not always hold true, of course, but is valid over the long term.

Yet it can also be argued that rising crude prices are driving the US dollar lower because they are putting a large burden on the global economy at a time when a recovery is within reach. A study by members of the IMF in 1996 found that a ten percentage-point rise in the real price of oil induces a 2% real depreciation in a typical OECD country’s real exchange rate. Higher oil prices increases the cost of oil imports, which in turn leads to a higher current account and trade deficit.

Oil at a Top?

The more important question for currency traders is whether oil prices have topped. From a dollar perspective, we expect the greenback to recover further this week after having become very oversold. There are also concerns that China will become less of a buyer in the second half of the year after having filled their coffers at low prices between January and May. We will be watching the Baltic Dry Goods Index for more evidence of this new trend. In the meantime, keep watching the commodities market for clues on where the Canadian, Australian and New Zealand dollars are headed next.

By Kathy Lien, Director of Currency Research at GFTForex.com

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