Oil and Forex: An Intimate Relationship

Although forex traders do not always have access to oil trading, due to regulatory constraints, trends in the oil market often have a very direct impact on their trading. The carry trade, for example, is strongly related to price movements in the commodity market where oil is one of the most important drivers.

However, even when the carry trade is not the main interest of a trader, oil prices are a major component of the calculations that determine price trends. To take a closer look at this relationship, let’s take a brief look at speculation, oil and forex, and the commodity markets.

Oil Prices and Inflation

Oil prices not only determine inflation, they are also a common ingredient of a large number of industrial products and consumer goods. Some of which include bags, tires, bottles, and myriad other items. As such, it’s safe to say that the price of oil has a direct relationship with inflation. Especially producer price inflation at the factory level, which determines trends in the price-pipeline. Also, due to the heavy weighting of fuel in the consumers basket, oil prices have a far greater transmission rate from the wholesale to the retail level. They are also more relevant to the CPI than other commodities.

All of these make central banks attentive to trends in this market. It is not unusual to see a particularly hawkish institution acting pre-emptively to forestall anticipated inflation by raising interest rates in response to oil price trends before such trends are felt in the consumers pocket. Given how important interest rates are to forex trends, the importance of the oil market is not difficult to observe.

Oil is a Major Speculative Tool

Although market commentators prefer to explain oil price trends in terms of fundamentals and supply and demand dynamics over the long term. Reality, as observed in the past decade, suggests that speculative trends and monetary policy often have a far greater bearing on the direction of the oil market than any collection of fundamental statistics. Due to the tendency of oil to generate great returns in a highly volatile environment over a relatively short period of time, speculators tend to pour in huge amounts of highly leveraged capital into the market in order to maximize returns.

The subsequent leveraging and deleveraging emphasizes price movements in a manner similar to the gyrations of carry trade currencies. In their turn, stock and public and private debt markets tend to mirror the oil market on the basis of the rationale explained in the previous paragraph, leading to highly directional financial markets in multiple asset classes. This, of course, makes the nature of a bubble much more violent and severe, intensifying profits, but losses, too.

These two factors lead us to conclude that the best way of profiting from oil market trends is maintaining a balanced portfolio of both producers and consumers to minimize the effects of volatility, and to capitalize on a small bias in positioning to generate long term returns. If you choose to form a portfolio purely made of oil producers, you are exposing yourself to a market that can at times move unbelievably fast, and maintain irrational positions for a long time.

You do not have to trade the commodity itself directly, although that can be an advantage depending on the circumstances. In fact, it may even be said that trading an oil currency is better than trading oil futures directly, since the currency has the added support of the economy of an entire nation. It’s unlikely to lose 90 percent of its value in a short time, which is hardly unseen in the oil market action.

Fundamental analysis explained

Read about the relationship between gold and inflation here.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.