Comments (1) In this current age of globalization, asset classes are developing correlations that financial markets have never seen before. One such correlation that has existed for some time is that which exists between the energy and foreign-exchange (fx) markets.
As a general rule of thumb, one of three investor attitudes typically rules financial markets:
- First, if the economic outlook is bright and investors are upbeat, then risk appetite — or greed — rules the markets.
- Second, if the clouds seem to be gathering on the horizon, and an economic storm is being forecast by economists and talking heads, then risk aversion — or fear — rules the markets.
- And third, if the economic outlook is unsure, then investors will be unsure of which moves to make, and indecision will rule the markets.
These three investor attitudes have a direct effect upon the relationship between energy and the fx markets.
Energy is a commodity, and commodities tend to outperform during times of risk appetite; but they tend to underperform during times of risk aversion.
The reason for this is simple: Much of the demand for energy in the world is by businesses.
When the economy is doing well and businesses are expanding, there is an increased demand for energy in order to satisfy these expanding business ventures. However, when the economy begins to slow down, or even contract, the demand for energy will likewise tend to taper off due to the decreased business expansion.
Now, there are other factors that will drive energy prices, such as the economic forces of supply and demand. If the economy is in a recession, there will typically be less demand for energy, which means energy prices will fall.
However, if during the recession, a war breaks out in the Middle East and there is a threat of limited oil supply, we will see energy prices skyrocket.
Thus, geopolitical events can always disrupt normal market conditions.
Now, the relationship between energy and the fx market is currency specific.
For example, a country that is a heavy exporter of oil will be very dependent on the price of energy. If energy prices are rising, this country’s currency will tend to rise as well, as its economy is growing and capital is flowing into the country.
However, if energy prices fall, then this country will suffer economically — and its currency value will likewise fall as capital flows into the country dry up and there is less demand for its currency.
These currencies that are heavily dependent on the movement of commodities are referred to as commodity currencies.
This group of currencies includes the Australian Dollar, the New Zealand Dollar, the Brazilian Real, and the Canadian Dollar.
The Australian Dollar has a very special relationship with gold, due to its heavy mining and exporting business. The Canadian Dollar, however, is the energy currency.
Among developed nations, Canada is one of the few net exporters of oil, which means it exports more oil than it imports. It also has the world’s second largest oil reserves behind kingpin Saudi Arabia.
Oil exporting is such a large part of Canada’s economy that its economic well-being tends to be very dependent on energy prices.
This chart shows the incredibly tight correlation in the price of oil and value of the Canadian Dollar versus the U.S. Dollar. Nearly without fail, as the price of oil rose during this 5 year period, so did the Canadian Dollar. As the price of oil fell, so did the Canadian Dollar.
It is statistically estimated that the Canadian Dollar currently holds an 80% positive correlation with the price of oil.
While the Canadian Dollar holds a positive correlation with the price of oil due to its large exporting activities, there are also currencies that hold an inverse relationship with the price of energy.
On the other end of the spectrum from Canada is Japan. Japan has very little domestic energy supply, and therefore is a huge net importer of oil. Due to this fact, as the price of oil increases, the Japanese economy suffers. Conversely, when the price of oil falls, the Japanese economy is supported.
This is because, as the price of oil rises, Japan, of course, has to pay significantly more for the same amount of oil.
So, those who are trading currencies will oftentimes trade the Canadian Dollar versus the Japanese Yen in order to take advantage of this relationship.
If oil prices are expected to rise, then the CAD/JPY will also tend to rise as the Canadian Dollar gets strong and the Japanese Yen gets weak.
Although other currencies hold various degrees of positive and negative correlation with the price of oil, these two currencies — the Canadian Dollar and Japanese Yen — are the strongest, due to their strong economic relationship to oil prices.
**Michael Trinkle is a writer for ForexTraders.com; an educational/informative resource center for the currency exchange market.
Subscribe to