Oil Prices And The Foreign Exchange Market – Guest Post
In today’s complex global economy, everything is connected. The advance of technology and communication over the last few decades has served to create an ever-increasing connectedness across multiple asset classes. However, one of the clearest correlations that exists is the one between the price of oil and specific currency prices in the foreign exchange market.
The oil market is highly volatile. In history, spikes in the price of oil have been a cause of major recessions, economic hardships, and even wars. As a general rule of thumb, when the price of oil rises too quickly, it threatens to destabilize developed economies because too fast of an increase in oil prices makes transportation and many business operations much more expensive, which in turn forces companies to charge more for goods and services, which in turn can result in strong inflation.
Therefore, since the oil market is so volatile, companies that are exposed to financially to the price of oil will engage in the oil market by purchasing options and futures contracts in an attempt to hedge against wild volatility in the market. At the same time, the oil market is a favorite among speculators because of its rather sharp daily price movements. In this article, we are going to discuss the tight correlation that exists between the oil and currency markets.
As a general rule of thumb, countries that have an economy heavily depended on oil imports or exports tend to have currencies that are heavily influence by the price of oil. For example, if a country is a leading exporter of oil, then that country will do very well when the price of oil is low because demand for its oil exports will rise. However, when the price of oil is high, that country will face economic hardship because demand for its exports will decrease.
On the other side of the spectrum, you have countries that import oil. If a country does not have a very strong ability to domestically produce oil, then it will be forced to import all of its oil. This makes a country very dependent and exposed to the price of oil. When the price of oil is high, these countries will suffer economic hardship because they will be paying a much higher price for oil. However, when the price of oil is low, they will be able to purchase more oil at a smaller per unit price.
Canada and Japan
Therefore, one of the major focuses of currency traders is to pair two countries together—one that is a heavy net exporter and one that is a heavy net importer of oil—and trade that specific currency pair. The biggest net exporter of oil in the developed world is Canada, and the biggest net importer of oil in the developed world is Japan. Thus, the Canadian Dollar/Japanese Yen currency pair is a favorite amongst forex brokers and currency traders who also focus on the price of oil.
When the price of oil rises, the CAD/JPY tends to rise aggressively. In contrast, when the price of oil drops, the CAD/JPY tends to fall. Therefore, a speculator can analyze the oil market, and if he feels that he has a strong conviction that price will move in a specific direction over a period of time, a trader can take an appropriate position in CAD/JPY.
Jason Hoerr is trading full-time from his home office in Charlotte, NC.