The foreign exchange market, or FOREX, is essentially a network of Central Banks, large commercial and investment banking institutions, brokerages, and hedge funds that trade currencies. International corporations are in constant need of the services that this market provides as they are based in one country but must buy materials, pay workers, and conduct business in the currency of another country. Forex traders, however, may not have the same need for currency exchange but may still make profits based upon the rise and fall of exchange rates.
Forex trading involves the purchase of one currency while simultaneously selling another. Forex trading involves a currency pair – like the USD and the Euro. There are actually several currency pairs for investors to choose from but the USD/Euro pair remains the most popular at the present time. The base currency is the first in the pair and it is used to initiate the account for trading purposes. For the USD/Euro currency pair, a 1.300 exchange rate means that it takes 1.300 U.S. dollars to purchase one Euro. The minimum amount that an exchange rate can fluctuate is .0001, or one pip (also referred to as a point). This is why an exchange rate would be listed as 1.200 rather than 1.2. All pips are not equal and their value is determined by dividing .0001 (one pip) by the current exchange rate and then multiplying the lot size of the transaction. A standard lot size in currency transactions is 100,000 units but there are also mini and micro lots, 10,000 and 1,000 units respectively.
Currency exchange rates tend to be affected by macroeconomic variables, such as the major economic indicators released by governments at fixed intervals. For instance, the Gross Domestic Product (GDP), unemployment rate, and even current interest rates (prime rates) can all affect currency exchange rates. However, it is possible for major political events (such as elections, wars, etc.) to also affect currency exchange rates. Even commodities (gold, oil prices, wheat, etc.) may affect the exchange rates between countries.
But 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. When the domestic economy is greatly affected by commodity price shifts, then the currency is especially vulnerable. Even for nations whose currency is strongly correlated with commodity pricing, different commodities will affect the currency differently (or perhaps not at all). By knowing which commodities are strongly correlated to which countries, an FX trader can better predict how commodity price shifts will affect currency exchange rates. Oil and gold are two commodities whose pricing is strongly correlated with the currency rates of Australia, New Zealand, Canada - and to a lesser extent, Japan.
Canada and its dollar are certainly very much affected by oil prices. In 2005, not only did oil prices reach record highs, they proved just how volatile they had become in our world. Peak oil prices in 2005 were nearly 70% higher than they were at the beginning of the year. The apex of crude prices was reached soon after Hurricane Katrina and prices began dipping soon afterward. By the time December 31st rolled around, the final price of crude settled at 40% above what it began 2005 with. With such volatile price movements, it is clear to see that nations with currencies tied to oil prices had a very interesting year in 2005.
The strength of the Canadian dollar has risen as a result of the higher oil prices and should continue to do so as long as oil prices continue to climb. In fact, there is a positive correlation of .78 between gas prices and the Canadian dollar – but why? Well, Canada has the second largest known reserves of oil – second only to Saudi Arabia. Also, ever since the turn of the new millennium, Canada has been the largest supplier of oil to the U.S.- even surpassing Saudi Arabia! Therefore, strong oil prices and increasing volatility in the Middle East actually strengthen the Canadian dollar.
For Japan, 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. But, when they drop significantly, Japan also has a windfall of additional money to pour into the other segments of its economy. The bottom line is that FX investors should look for opportunities with the yen any time there are significant changes in oil prices.
Gold is another commodity that saw record prices in 2005 and is expected to see continued increases in the years to follow. The supply of gold on the world market is not keeping pace with demand. Gold producers have not invested in finding new mines and the current ones are becoming less profitable to operate. A number of recent mergers and mine closures illustrate how the supply of gold is dwindling. Demand, however, continues to increase especially as the economies of China and India continue to heat up and give consumers in those nations more disposable income - which many choose to spend upon gold products as investment opportunities. Add to the rise of these Asian economies the fact that Central Banks around the world are now opting to increase reserves – and one can easily see how demand is quickly outpacing supply- and driving prices skyward as a result.
Australia, being the third-largest producer of gold, is clearly affected by the fortunes of gold prices - and so too is its currency. There is a correlation of .85 between the Australian dollar and gold prices. Therefore, gold price increases almost always strengthen the Australian dollar while decreases will weaken it relative to most other currencies. In a less direct way, the strength of the New Zealand dollar is also correlated with gold prices as well.
Australia is the number one destination for New Zealand exports. When the Australian dollar is strong due to gold prices, New Zealand will export more to their number one trading partner – due to the increased purchasing power of the Australian dollar. But, when the Australian dollar weakens, New Zealand exports tend to decrease. However, the relationship is even more interesting where exchange rates are concerned because the New Zealand dollar has an even stronger correlation with gold prices than does Australia – despite the fact that it does not produce near as much of the yellow metal as its neighbor. Why is that?
Australia is a huge producer of gold and it clear to see why its currency would be highly correlated with the prices of this precious metal. However, the overall impact of gold on the Australian economy is not as large as the overall impact on the New Zealand economy when the purchasing power of Australia changes – for better or worse. In other words, falling gold prices may hurt Australia and its purchasing power – but not nearly as much as it hurts New Zealand to see its exports fall off when its wealthy neighbor ceases buying as many imports as before. Therefore, gold prices more dramatically influence currency rates in New Zealand, but in a far less direct manner than they do in Australia.
At the end of the day, Forex investors can indeed predict (with great reliability) currency rates based upon commodity price shifts. However, the investor needs to understand which nation’s currencies are vulnerable to commodity prices and how. The correlation, as is the case with New Zealand and gold, may not be direct but it can still be stronger than for nations actually producing and using the commodities in question.