Commodity Pairs: Currency Correlations Explained

What Are the Commodity Pairs?

The commodity pairs, or commodity currencies, are those forex currency pairs from countries with large amounts of commodity reserves. These pairs are highly correlated to changes in commodity prices since the countries produce and export various commodities. Traders and investors seeking exposure to commodity price fluctuations often take positions in commodity currency pairs as a proxy investment for buying commodities.

The commodity pairs include pairing the U.S. dollar (USD) with the Canadian dollar (CAD), Australian dollar (AUD), and the New Zealand dollar (NZD). The Russian ruble (RUB), Brazilian real (BRL), and Saudi riyal (SAR) are also currencies sensitive to the prices of commodities.

Understanding Commodity Pairs

Commodity pairs offer benefits to investors because they are among the most widely traded currency pairs on the foreign exchange (FX) market. Forex trading is the act of taking positions in the exchange rates of various currencies. Forex trades involve buying and selling foreign currencies at their prevailing exchange rates with the goal that the rate will move in the investor's favor.

A U.S.-based trader, for example, might buy the Australian dollar versus the U.S. dollar exchange rate (AUD/USD) at the prevailing rate of 0.7500, which translates to 75 U.S. cents for one Australian dollar. If the exchange rises to 0.8500, the trader would book an offsetting trade to close out the position and pocket the profit of 0.1000 cents (minus the broker fees or charges).

In forex trading, there is no actual delivery of the currency. Instead, the offsetting trade closes out the position, and the net amount earned or lost is exchanged and processed through the trader's brokerage account.

Liquidity

The market for commodity pairs tends to be very liquid, which is a market where trades can be executed with ease since there are plenty of buyers and sellers available. Conversely, an illiquid market can lead to traders experiencing difficulty in exiting a position due to a lack of market participants.

Also adding to the liquidity of commodity pairs is the stability of their economies, which back the currencies. These characteristics make commodity pairs attractive to traders who want to have the potential for profits while moving in and out of trades quickly.

Other Commodity Countries

Although there are many countries with significant natural resource and commodity reserves, such as Russia, Saudi Arabia, and Venezuela, the commodities of many of these nations are usually highly regulated by their domestic governments or thinly traded.

Major Currencies in the Commodity Pairs Trade

The three countries that make up the non-U.S. components of the trio of commodity pairs all have specific qualities that make their currencies and commodity resources appealing to investors.

CAD

The value of the Canadian dollar to the U.S. dollar (USD/CAD) is highly correlated with the price of commodities, including oil. Canada’s vast regions of relatively unspoiled landscapes mean the nation is teeming with natural resources such as timber and fuels.

The Canadian economy is heavily reliant on the production and sale of commodities. Oil and fuels, for example, comprise the largest share of the country's exports. As a result, the price of oil is a major driver in the health of the economy.

Trading this pair is also known as trading the "loonie." Canada’s proximity to the U.S. means the two economies are closely tied, which shows in the export totals, with 75% of Canadian exports going to the U.S. in 2019.

AUD

Trading the Australian dollar to the U.S. dollar exchange rate is also known as trading the "Aussie." Australia is the most abundant global coal and iron ore exporter. Australia also has extensive areas of lush natural landscapes and is one of the most resource-rich nations in the world. The country also exports petroleum and gold, and its currency is, therefore, heavily dependent on these commodity prices.

Besides being a commodity currency pair, Australia also provides investors with insight as to how well China's economy is performing since China is the largest export customer of Australia. If Australia is increasing its exports to China, it's reasonable to conclude that economic growth is picking up in China. A strong Chinese economy bodes well for the rest of the world as well as Australia, which can increase the Australian dollar exchange rate due to the increase in demand for Aussie goods.

NZD

New Zealand is the world's biggest exporter of concentrated milk and also exports other dairy products, meat, and wool. New Zealand has a solid connection to gold and will react to movements in the commodity's price. Trading the New Zealand dollar to the U.S. dollar (NZD/USD) is also known as trading the "kiwi."

Also driving demand for the kiwi is that New Zealand typically has higher interest rates than many other countries. As a result, investors often send their money to the country to earn a higher yield. Some of those investors borrow the money in low-interest rate countries such as Japan and convert those borrowed funds (from Japanese yen) into NZD to invest in New Zealand banks.

This process of funding investment by borrowing from a low-yielding country to invest in a higher-yielding country is called the currency carry trade.