Forex Investment and Currency Trading

FX Bottom-line: A thought provoking asymmetrical relationship between CAD and commodity prices has developed since December 07. Traders are reluctant to buy CAD as commodity prices rally citing Canada’s close ties with the US, but are eager to sell CAD on commodity sell-offs as part of a broader risk aversion trade. This relationship is expected to continue until more evidence of a bottoming in the US economy emerges.

Unfamiliar Commodity Relationship for CAD

The emergence of China and a synchronized global growth cycle favoured commodity prices and CAD given Canada’s healthy mining sector and 173 billion barrels of proven crude oil reserves locked up in the Alberta Oil Sands. During the hey days of the commodity upswing between 2003 and early 2007, FX traders were more willing to buy CAD on commodity price rallies than sell CAD on negative days for commodities.

But with the US housing and credit problems intensifying in H2 2007 and increased chatter about a US recession, CAD became less responsive to commodity price rallies. The co-movement between CAD and commodity rallies also fell during the latter part of 2007.

In its place, a clear asymmetrical relationship has developed, with CAD becoming increasingly sensitive to commodity sell-offs. Since December traders, already worried about the spillover impact from a US slowdown onto Canada, have used commodity declines as another opportunity to sell the currency, even against a generally weak USD. This asymmetrical risk is evident in both the co-movement ratio and sensitivity analysis between CAD and commodities. The correlation coefficient for CAD, using daily changes in the CRB index, confirms this new development, with CAD/USD declining 0.91% for every 1% decline in the CRB index between December 07 and March 08. This is well above the 0.32% between July and November 2007 and also well above the CAD coefficient for “up days” of 0.50 (Dec 07 - Mar 08) – i.e. the ratio 50:91 is clearly skewed to the bearish side. The change in net long CAD futures positions since December 07 also reflects the change in CAD sentiment.

The asymmetrical CAD-commodity relationship is not apparent in the antipodean currencies. The coefficients between daily currency and commodity moves reflect a more balanced view for both AUD & NZD, while the co-movement ratios for these currencies have not changed materially since 2003. Given the diverging outlook for the domestic economies of Canada and the antipodeans, AUD and NZD traders are not plagued by the same immediate concerns about aggressive monetary easing that is prevalent in Canada. Consequently, the sensitivity between AUD, NZD and commodities remain more balanced (AUD: 73:60, NZD: 68:64 compared to CAD: 50:91) and both currencies benefited from the latest commodity rally.

A symmetrical CAD-commodity relationship should return when evidence of a bottoming in the US economy emerges and extreme economic US pessimism subsides. Recommended Trade: scaling into a long AUD/CAD trade once it breaks above the recent channel top at 0.9400.