Friday, May 6, 2011

How Commodity Weakness Influences Currencies

Following yesterday's ECB press conference where ECB President Trichet failed to mention the magic phrase 'strong vigilance', commodities took a sharp turn down as market participants had overestimated the hawkishness of the ECB head. This was exacerbated by CME's decision to increase margin requirements on silver and to increase the limit size movements of several commodities, including oil which was down over 10% during the session as was silver. The wider CRB index dropped close to 5%. Without digging too deep into the inflation story we can conclude that a sizable portion of the price of several commodities has been purely speculative.

But how will this influence currencies?
Commodities are traded in dollars, a remnant of days past when the US dollar reigned supreme over other currencies. Countries that export commodities such as oil, natural gas, copper, gold etc. receive dollars for their goods. Ten or twenty years ago these dollars might have gone to US Treasuries or other assets denominated is US dollars but with the dollar in a long term bear market commodity producing nations are diversifying away from it. The more dollars they receive for their goods, the more they need to diversify. This diversification has taken the form of buying up euros, Swiss francs, Australian dollars, Chinese yuan, Brazilian real, Canadian dollars, British pounds, Swedish krona etc.

EURUSD in green (lhs) vs OIL in black (rhs), chart from

So as the price of oil goes up, one can reasonably expect an increase in the price of various currencies such as the euro and the Aussie dollar against the US dollar as countries look to sell dollar they received in exchange for their goods. It is important to realize that this is not a one-way street, this correlation works on the way up as well as it does on the way down. In fact the moves on the downside tend to be more violent due to extreme fear and forced liquidation.

So with oil and other commodities down we can expect to see pressure on the euro, the pound and various commodity and carry trade currencies. On the flip side we can expect to see strength on the US dollar and the Japanese yen. This correlation is not 100% so due diligence is still required - ie don't jump into a fiber short just because oil is down.

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