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Fx Commodity Corelation

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Seeing forex as an asset and commodity as a hedge to currency and forex

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Fx Commodity Corelation

  1. 1. or * See Profile on & linkedin.comFX is a Commodity, not an Asset ; “How to generate Alpha in FX as an Asset class”, is FX an asset at all?FX is not an Asset, but rather a Commodity : Some interesting observations about correlations among different marketsnote the following strong correlations:1) The DJIA to the US $ index2) The DJIA to the Reuters/Jeffries CRB index3) US $ index to gold4) US $ index to crude oilDJIA to US $ index: There is a strong negative correlation between the two.10 Years (1999-2008) -51%5 Years (2004-2008) -58%2007 -69%2008 -89%2009 -92%Note the higher correlation since the economic meltdown --conclusion was the $ index would remain weak due to stableinterest rates and that would produce one more rally in the DJIA looking for an Oct high.DJIA to Reuters/Jeffries CRB index--There is a strong positive correlation between the two.10 Years (1999-2008) 59%5 Years (2004-2008) 51%2008 86%2009 88%Conclusion - if the DJIA was set for another rally into Oct, then the CRB would also rally sometime in the 4th quarter.US $ index to gold and crude oil --There is a strong negative correlation between the $ index and both gold and crude oil.However, crude oils correlation has strengthened while golds has weakened.
  2. 2. 2007 US $/gold -91%2007 US $/crude oil -96%2008 US $/gold -76%2008 US $/crude oil -82%2009 US $/gold -64%2009 US $/crude oil -96%2010 Euro / Gold – negative inverse co-relationConclusion -- if the US $ index stays weak, crude oil was soon set for another rally even though there is aseasonal tendency for crude oil to weaken from the last week of Sep until the first week of Dec. One can takeargument with some conclusions but the strikingly high correlations in the $ versus crude oil and the $ versusthe DJIA need to be watched closely….On commodity marketsGreat bull run in commodities from 1906 – 23, 1933-53, 1968-82 average duration 18 years, new run beginsfrom 1999 and or 2003, can last till 2014 or 2022 Metal / mineral prices high but inflation adjustment can takethem higher in the next decade from time to time. In 2006 summer cotton , soybean, sugar, coffee, wheat, corn, rubber, rice, prices on an average 50-66% lowerthan all time high. Perhaps 70-80% by inflation adjusted levels. Commodities will function with its owndemand supply disruption, new find scenario , with each having its own phase of correction and up treads.There will be supply shocks in some and demand driven trends in others Inflationary trends will be up due to high price of commodities, thus interest rates will be on a vicious cyclefrom time to time, thus share prices will move inversely against commodities ; As the dollar weakness will bea wind behind this commodity uptrend --commodity currency’s like the Canadian $ will be firmer over thenext decade. Does not have the features of an asset; FX is not an asset because it hasnt got that most essential feature of anasset, which is to provide a utility to the asset holder independent of any changes in the price of the asset afterits purchase, for significantly long periods of time after its purchase. For instance, a car provides the utility oftransport, a house provides the utility of shelter, a factory produces the utility of production and so on. All ofthese assets are fed with some inputs – car with fuel, house with electricity, factory with raw materials - andthey produce the utility they are meant to provide. Their ability to produce utility is dependent on thecontinued supply of inputs, and not on any extraneous change in the market price of the asset itself. Of course,looking at it the other way round, the market price of an asset can vary in accordance with its ability/ inabilityto produce the desired utility, but thats a different point altogether.
  3. 3. Financial assets such as stocks, bonds or bank deposits provide the utility of returns by the very virtue ofownership – either interest in the case of bonds and deposits, or dividend (in most instances) in the case ofstocks. These returns are accruable to the owner, irrespective of the changes in the market price of the stocks/bonds. The prices of all assets, whether physical or financial, can rise or fall – producing capital gains or losses– but all assets continue to provide, over time, the utility they are supposed to provide, irrespective of theseprice changes. Yes, all physical assets depreciate with wear and tear, which reduces their ability to provideutility, but that is, as said earlier, another matter.Currencies do not have this characteristic of assets. Currencies are a means of exchange. They are used to buyassets or commodities. Yes, they do provide a utility – they enable the exchange of goods and services, theyenable commerce. But the provision of this utility is dependent on the price of the currency itself, throughinflation/ deflation in the domestic arena or through appreciation/ depreciation vis-à-vis other currencies inthe international arena. This is an essential difference between currencies and other assets. Further, unlikefinancial assets like stocks, bonds or bank deposits, the mere possession of currencies does not necessarilyprovide a return. You would have to make a deposit in a bank to earn interest. Note then, that it is the depositthat earns interest, not the currency itself. Yes, there can be gains or losses due to changes in the price of thecurrency, but the currency itself produces no returns. As such, it would seem that whatever else currenciesmight be, they are not assets.More like a commodity ; Perhaps currencies are more akin to commodities? Most commodities, such as fuel,metals, wood, chemicals and others, become useful when used as an input in a productive process. The merepossession of the commodity does not necessarily produce a benefit. Similarly, currencies produce a benefit orutility when used as a means of exchange in trade and commerce and in capital transactions. Further, theholding period for most commodities, especially in the physical form, tends to be short. This is in contrast toassets, which the Average Joe wants to hold for a long period of time. Holding a commodity is seen as holdinginventory and no one wants to hold inventory for very long, because there are costs attached to carrying thatinventory.Apart from the cost of storage, the biggest cost of holding commodities is the risk of a fall in prices. Of course,there are chances of prices rising as well, but statistically, the chance of a rise in commodity prices tend to bemore or less equal to the chances of a fall over a long period of time. Similarly, the holding of currencies bringswith it more or less equal chances of a rise or fall in prices. This is unlike the case of assets (like houses, orfactories, or gold or brand name), where the chances of a rise in prices are, in the long run, greater than thechances of a fall. There is, thus, prima facie, a disincentive for most people to hold onto commodities orcurrencies for very long periods of time, or in excess of their requirements, especially in the physical form.Of course, an entire industry thrives on the holding of commodities. But, this is usually in the form of futuresor options. Here too, we find that the holding period for most futures or options tends to be rather short,especially in comparison with the holding period for even financial assets. The open interest in most Futuresmarkets, for both commodities and currencies, tends to be concentrated in the first three months, with the firstmonth having the highest open interest. People are, for the most part, interested in trading the commodity orthe currency, buying and selling it for small profits in short periods of time. Few people tend to hold acommodity or currency futures for periods beyond three months. In fact, a few minutes to a few hours is thenorm for the greater number of participants in the currency market. Clearly, therefore, gains in the currencymarket are in the nature of trading gains (which is a characteristic of commodities), rather than capital gains(which is a characteristic of assets).
  4. 4. * See articles & notes in & & www.slideshare.netFurther, it is an oft-quoted fact that the global currency market is the biggest market in the world, withvolumes approaching $3 trillion per day. The market for the G7, or Major, currencies is highly liquid and notamenable to “cornering” or “price rigging”. Individual participants in the market have no hope of influencingprice. So much so that these days even Central Banks, especially of the G7 countries, have largely given up onthe practice of Intervention. The global currency market is the closest that one can ever come to the utopianconcept of Perfect Competition in a market, where there are a large number of participants, there is no barrierto entry or exit of participants and everybody shares instantaneous and complete information.In effect, the global currency market is a wholesale market, the biggest of them all. And, wholesale marketsdeal in commodities, not assets. We do not find Rembrandts, Picassos, Van Goghs, or Bikash Bhattacharjeesbeing traded in wholesale markets. Maruti 800s, and even Honda Citys, are commodities, when compared tocars like Ferraris and Porsches, leave alone F1 cars.How does this help? Alright, suppose the debate is settled, or at least, it is personally settled for me (untilsomeone with better logic unsettles me) that currencies are commodities, not assets, how does that help ingenerating better returns, or Alpha?Firstly, we realize that all “returns” in commodity (and currency) trading is Alpha because the commodityproduces no returns on its own. Secondly, we can shun some of the techniques of investing in assets, such as“Buy and Hold”. Thirdly, we realize that while all returns in currency trading is Alpha, the Alpha, in turn, isgenerated from trading. Thus, we start looking for ways of trading better.We can draw inspiration from the fruit or vegetable seller, whether he be running a small shop, or he be awholesaler. Both look to make a small margin on each sale and would rather let the stock go at cost than to seeit go waste at the end of the day, resulting in a loss. He does not look to, on an average, make more per kilo orounce sold, than is available in the market at the going price.Cut to the currency market ; If we act like the fruit seller, we will change our tactics. Instead of trying to figureout things like, “Is the Euro, or the Yen, going to go up or down”, we will try and spend more time workingout how much profit per trade is generally possible to achieve. Having known that, we will try and increasethe number of trades we do wherein we can get that average profit per trade we are looking for. This will alsohelp us control our greed and we will not mind cutting losses fine and getting out of a trade at a meagre profit,or at cost, or at worst, a meagre loss. Disinvesting ourselves of the notion that we are investors will help usbecome better Currency Traders and thus help us generate Alpha. Did Deflation fears really help rally the oil markets ? Oil prices popped as the dollar index dropped hittingthe lowest level since last April. The market seems convinced that the Euro zones problems are behind us so itappears that the carry commodity trade is back in play but could we see more problems up ahead? Of coursewhile the dollar has been trending lower and the Euro higher is this a sign that we are headed for a bout ofcommodity price inflation or are the markets more worried about deflation?
  5. 5. This kind of talk of course is bullish for commodities. As I have said from the first day that the Fed went toquantitative easing that the Fed just printed a floor under commodities. By creating inflation and money out ofthin air the Fed changed not only the underlying value of a depreciated dollar but its entire price structure inregards to other commodities. If the Fed chooses they can create commodity price inflation and they hopesome demand as they try to inspire economic activity by flooded the world with dollars.This is why oil prices remain stubbornly high despite a global glut of supply. Quantitative easing andessentially negative real interest rates has probably added a $10 to $25 a barrel premium to a barrel of oil.With the talk or more quantitative easing being too short commodities is a more dangerous proposition.At anytime they can run the printing press and change the fate of a commodity or at least its price. Of coursethere are dangers to this policy. If the printing of money cannot inspire banks to lend and stir economicactivity and job creation then all that is left is commodity price inflation that may restrict the type of growththat is necessary to promote the type of economic activity to restore the economy back to a normal path. Sowhat now should be apparent that at this stage of the recovery we now know that the Fed cannot do it on itsown? The Fed has done what it had to do but now it now up to the lawmakers down in Washington. The nextstep that has to be taken is to make a plan to bring out of control spending under control and to cut corporatetax rates to restore confidence. Expect volatility and fear to continue in the face off policy imbroglios in mostmajor currency capitals……… or * See Profile on &