Aussie's shifting correlation with gold

September 15, 2010, 12:34 pm By Kathy Lien kathylien

When the global economy begins to grow, the correlation between gold and the AUD/USD could resume

Ask anyone on George Street in Sydney what Australia's economy relies on, and they will most likely tell you that the nation's wealth is directly tied to commodities.

Australia is a huge producer of iron ore, coal and gold, which have seen great demand from China. In fact, thanks to these commodity exports, China has become Australia's number one trading partner. Australia is China's sixth most important import supplier. This strong dependence on commodities has given the Australian dollar the label of "commodity currency." This means investors expect the Australian dollar to move in lockstep with commodity prices.

For many years, currency traders focused only on the correlation between the Australian dollar and gold, attributing intraday movements to the price action of the yellow metal. As the currency of the world's second largest producer of gold, the Aussie often moved in lockstep with gold. Australian dollar traders could base their positions on where they thought gold prices were headed.

Looking at past trends

Between 2002 and 2005, this worked well, because the Aussie had a mindboggling 95 percent positive correlation with gold. However, in the past year that has not been the case. From 1 January to 31 July, gold prices rose approximately eight percent while the Australian dollar remained virtually unchanged. Not only has the correlation completely broken down, but it actually turned negative, which means the Australian dollar would fall when gold prices rose and vice versa.

This happened because the US dollar started to trade on safe haven flows. In other words, whenever investors were nervous, they would buy the US dollars and sell Australian dollars. At the same time however, gold also moved in response to safe haven demand. So when investors were nervous, they would buy US dollars and gold, which drove the AUD/USD lower. When the concerns receded and the market stabilised, those same investors would dump gold and sell US dollars.

The following table shows how the correlation between the Aussie and gold has shifted over the past two decades. The correlation was the strongest between 2000 and 2010, when the Australian dollar would move in the same direction as gold 80 percent of the time. Over the past three years, the correlation deteriorated quickly. It is certainly not a coincidence that this occurred during the global financial crisis.


Source: Bloomberg, FX360.com

Yet, just because the Aussie is no longer correlated with gold does not mean it should lose its commodity currency status. In fact, there is one commodity whose relationship with the Australian dollar has been consistent over the past two decades - copper. For the past 20 years, the correlation between copper and the Aussie has exceeded 70 percent. Over the past three years, the correlation hit as high as 93 percent. It has deteriorated since then, but only marginally.

Although copper may not be one of Australia's top commodity exports, it is still equivalent to more than AUD$5 billion of annual trade. The following table shows how the correlation has held over time. The relationship can also been seen in the following chart.


Source: Bloomberg, FX360.com


Source: Bloomberg, FX360.com

Watching the trends of copper can help Australian dollar traders in their trade selection process. If copper looks like it is at the brink of breaking out, there is a good chance the Aussie could do the same as well. But remember, correlations will change with time. When the global economy begins to grow, the correlation between gold and the AUD/USD could resume.

At the same time, there could be future months where the Aussie does not trade in lockstep with copper. These relationships can be useful in the long run, but should not be used as your only selection criteria.

Do you think the correlation between the Aussie and gold will return? (Share your views below)

Want to learn more about trading CFDs? Download GFT's free CFD guide, get a risk-free practice account and visit gft.com.au for more information. Ready to start trading? Open an account with GFT with as little as $275. Don't forget to follow Kathy's commentary on FX360.com and Twitter.

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