Trading Commodity/Currency Correlation

01/04/2012 3:30 pm EST

Focus: COMMODITIES

Daniel Collins

Editor-in-Chief, Modern Trader

US dollar weakness has impacted a number of commodities and currencies that are tied closely to it, says Dan Collins, reviewing short- and longer-term implications for traders.

Traders have seen a lot of correlation between some currencies and commodities these days, and our guest today is Dan Collins to talk about that. So Dan, what is this connection between commodities and currencies?

Well it is a real basic connection, because everything is traded in some money, usually the US dollar. 
So when the dollar moves, that is going to affect the price of these commodities. 

I think some people don’t look at that as often as they should, because obviously, you can see it clearly with gold and the dollar; you can see it with crude oil and the dollar.

That always has to be looked at, along with the other, regular fundamentals or technicals that you may look at. 

So talk about how I trade this. If I am trading the Canadian dollar because I know it is connected somehow to the price of oil, does one lead the other to give me time to get into a trade?

Well, I think you use all the tools you have, because I would say that the currency would probably lead the commodity if there is a big movement in the currency, but it works both ways. 

The good thing about that—and Jeff Greenblatt and Sam Seiden have spoken about this—is that everything is correlated with the dollar in a certain way, all the commodities. 

So if you see a big move there, you can use that to kind of select which one is maybe reacting the most, which one has the ability to get a lower-risk trade on. If there is a technical spot that you know it’s not going to move beyond, you can play it, and if you’re wrong, then you have a really tight stop.       

Is there a stronger correlation these days with currencies and commodities than there has been in the past?

There seems to be, whether it is the dollar or the stock market. We have seen a really strong correlation starting in 2008. 

There are still a lot of theories out there. I think with the dollar being so much at a historic low that sensitivity may be a little bit more, so the markets are at extremes.

I think we have had heard a lot of traders recently talking about a strong dollar because there is a flight to safety. Do you have any input on that? Do you see that continuing?

It is a very peculiar reaction, because the dollar has been going down for over a decade. Then, when things get really ugly, it goes up because it may be weak, but it is the only reserve currency we have right now. 

Weakness hurts it in a general sense, but global weakness strengthens it because it is the only reserve currency. It is not a typical correlation. At some point, you think it would get back to normal.

How about inflation? Is it a worry for you? Do you see that affecting commodities, and are we going to see a price increase there?

Inflation is a very controversial subject right now, because people have been worried about it for a long time.  With the quantitative easing, which is basically printing money while keeping low interest rates for many years—you know, we could have five years with zero interest rate policy—many would view that as inflationary. 

We saw inflation when the commodities came up. I think the Federal Reserve frustrated a lot of people when they talked about no inflation and they can see prices going higher, but the structural inflation is a worry. We are going to have to see how it plays out.

Where will you see it first?

Well, I like to kind of keep it simple and look at prices. That is inflation.

Is there a more specific sector?

Well you see it in the agricultural sector because you are seeing with China, besides the fact that they are buying our dollars, they have a demand for meat when the economy does better. That is a big driver in the price of the grains.

You have also seen it with the use of ethanol. That is not technically what the Fed would call inflation, but it would be what everyone else out there who has to buy goods and services and pay for gas would call inflation.

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