books about online stock trading, forex, futures, stock investing, market, trading systems
Commodity Prices As A Leading Indicator
back to contents page

Short-term traders seem to be focused only on the economic release of the week and how it will impact their day trading activities. This works well for many traders, but it is also important not to lose sight of the big macro events that may be brewing in the economy — or the world for that matter. The reason is because large-scale macroeconomic events will move markets and will move them big time. Their impact goes beyond a simple price change for a day or two because depending on their size and scope, these occurrences have the potential to reshape the fundamental perception toward a currency for months or even years at a time. Events such as wars, political uncertainty, natural disasters, and major interna­tional meetings are so potent due to their irregularity that they have wide­spread psychological and physical impacts on the currency market. With these events come both currencies that appreciate vastly and currencies that depreciate just as dramatically. Therefore, keeping on top of global developments, understanding the underlying direction of market senti­ment before and after these events occur, and anticipating them could be very profitable, or at least can help prevent significant losses.

Know When Big Events Occur

•  Significant G-7 or G-8 finance ministers meetings.

•  Presidential elections.

•  Important summits.

•  Major central bank meetings.

•  Potential changes to currency regimes.

•  Possible debt defaults by large countries.

•  Possible wars as a result of rising geopolitical tensions.

•  Federal Reserve chairman's semiannual testimony to Congress on the economy.

The best way to highlight the significance of these events is through examples.

G-7 Meeting, Dubai , September 2003

The countries that constitute the G-7 are the United States , United King­dom , Japan , Canada , Italy , Germany , and France . Collectively, these countries account for two-thirds of the world's total economic output. Not all G-7 meetings are important. The only time the market really hones in on the G-7 finance ministers meeting is when big changes are expected. The G-7 finance ministers meeting on September 22, 2003 , was a very important turning point for the markets. The dollar col­lapsed significantly following the meeting at which the G-7 finance min­isters wanted to see “more flexibility in exchange rates”. Despite the rather tame nature of these words, the market interpreted this line to be a major shift in policy. The last time changes to this degree had been made was back in 2000.

Figure 9.9 EUR/USD Post G-7 Chart

In 2000, the market paid particular attention to the upcoming meeting because there was strong intervention in the EUR/USD the day before the meeting. The meeting in September 2003 was also important because the U.S. trade deficit was ballooning and becoming a huge issue. The EUR/USD bore the brunt of the dollar depreciation while Japan and China were intervening aggressively in their currencies. As a result, it was widely exacted that the G-7 finance ministers as a whole would issue a statement that was highly critical of Japans and Chinas intervention poli­cies, leading up to the meeting, the U.S. dollar had already begun to sell off, as indicated by the chart in Figure 9.9 . At the time of the announce­ment, the EUR/USD shot up 150 pips. Though this initial move was not very substantial between September 2003 and February 2004 (the next G-7 meeting), the dollar fell 8 percent on a trade-weighted basis, 9 percent against the British pound, 11 percent against the euro, 7 percent against the yen, and 1.5 percent against the Canadian dollar. To put the percent­ages into perspective, a move of 11 percent is equivalent to approximately 1.100 pips. Therefore the longer-term impact is much more significant than the immediate impact, as the event itself has the ability to change the overall sentiment in the market. Figure 9.9 is a weekly chart of the EUR/USD that illustrates how the currency pair performed following the September 22, 2003 , G-7 meeting.

Political Uncertainty: 2004 U.S. Presidential Election

Another example of a major event impacting the currency market is the 2004 U.S. presidential election. In general, political instability causes per­ceived weakness in currencies. The hotly contested presidential election in November 2004 combined with the differences in the candidates' stances on the growing budget deficit resulted in overall dollar bearishness. The sentiment was exacerbated even further given the lack of inter­national support for the incumbent president (George W. Bush) due to the administrations decision to overthrow Saddam Hussein. As a result, in the three weeks leading up to the election, the euro rose 600 pips against the U.S. dollar. This can be seen in Figure 9.10. With a Bush victory becoming increasingly clear and later confirmed, the dollar sold off against the ma­jors as the market looked ahead to what would probably end up being the maintenance of the status quo. On the day following the election, the EUR/USD rose another 200 pips and then continued to rise an additional 700 pips before peaking six weeks later. This entire move took place over the course of two months, which may seem like eternity to many, but this macroeconomic event really shaped the markets; for those who were fol­lowing it, big profits could have been made. However, this is important even for short-term traders because given that the market was bearish dollars in general leading up to the U.S. presidential election, a more pru­dent trade would have been to look for opportunities to buy the EUR/USD on dips rather than trying to sell rallies and look for tops.

Figure 9.10 EUR/USD U.S. Election

Wars: U.S. War in Iraq

Geopolitical risks such as wars can also have a pronounced impact on the currency market. Figure 9.11 shows that between December 2002 and February 2003, the dollar depreciated 9 percent against the Swiss franc (USD/CHF) in the months leading up to the invasion of Iraq . The dollar sold off because the war itself was incredibly unpopular among the inter­national community. The Swiss franc was one of the primary beneficiaries due to the country's political neutrality and safe haven status. Between February and March, the market began to believe that the inevitable war would turn into a quick and decisive U.S. vi ctory, so they began to unwind the war trade. This eventually led to a 8 percent rally in USD/CHF as in­vestors exited their short dollar positions.

Each of these events caused large-scale movement in the currency markets, which makes them important events to follow for all types of…

all have solid correlations with gold prices; natural gold reserves and currency laws in these countries result in almost mirror-like movements. The CAD also tends to move somewhat in line with oil prices; however, the connection here is much more complicated and fickle. Each cur­rency has a specific correlation and reason as to why its actions reflect commodity prices so well. Knowledge of the fundamentals behind these movements, their direction, and the strength of the parallel could he an effective way to discover trends in both markets.

The Relationship

Gold Before analyzing the relationship gold has with the commodity currencies, it is important to first understand the connection between gold and the U.S. dollar. Although the United States is the worlds sec­ond largest producer of gold (behind South Africa ), a rally in gold prices does not produce an appreciation of the dollar. Actually, when the dollar goes down, gold tends to go up, and vice versa. This seem­ingly illogical occurrence is a by-product of the perception investors hold of gold. During unstable geopolitical times, traders tend to shy away from the dollar and instead turn to gold as a safe haven for their investments. In fact, many traders call gold the "antidollar." Therefore, if the dollar depreciates, gold gets pushed up as wary investors flock from the declining greenback to the steady commodity. The AUD/USD, NZD/USD, and USD/CHF currency pairs tend to mirror gold's move­ments the closest because these other currencies all have significant natural and political connections to the metal.

Starting in the South Pacific, the AUD/USD has a very strong posi­tive correlation (0.80) with gold as shown in Figure 9.12; therefore, whenever gold prices go up, the AUD/USD also tends to go up as the Australian dollar appreciates against the U.S. dollar. The reason for this relationship is that Australia is the worlds third largest producer of gold, exporting about $5 billion worth of the precious metal annually. Because of this, the currency pair amplifies the effects of gold prices twofold. If instability is causing an increase in prices, this probably sig­nals that the USD has already begun to depreciate. The pairing will then be pushed down further as importers of gold demand more of Australia 's currency to cover higher costs. The New Zealand dollar tends to follow the same path in the AUD/USD pairing because New Zealand 's economy is very closely linked to Australia 's. The correlation in this pairing is also approximately 0.80 with gold (see Figure 9.13 for the chart).

Figure 9.12 AUD/USD and Gold

Figure 9.13 NZD/USD and Gold

The CAD/USD has an even stronger correlation with gold prices at 0.84, …

Figure 9.13 CAD/USD and Oil

Trading Opportunity

Now that the relationships have been explained, there are two ways to exploit this knowledge. Taking a look at Figures 9.12, 9.13 and 9.14, you can see that generally speaking, commodity prices are a leading in­dicator for currency prices. This is most apparent in the NZD/USD-gold relationship shown in Figure 9.13 and the CAD/USD-oil relationship shown in Figure 9.14. As such, commodity block traders can monitor gold and oil prices to forecast movements in the currency pairs. The second way to exploit this knowledge is to parlay the same view using different products, which does help to diversify risk a bit even with the high correlation. In fact, there is one key advantage to expressing the view in currencies over commodities, and that is that it offers traders the ability to earn interest on their positions based on the interest rate differential between the two countries, while gold and oil futures posi­tions do not.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading
The Five Rules For Successful Stock Investing
Forex Conquered -High Probability Systems and Strategies
Robert Kiyosaki - Rich Dad's Guide To Investing What The Rich Invest In Rich Dads Prophecy