Gold and The Aussie Correlation

The gold price and AUD/USD have a strong correlation historically. This stable relationship is cemented as Australia is the world’s second-largest gold producing country after China, and the reason why the Aussie is known as a "commodity currency".

The Correlation

This correlation exists between different asset classes because the markets are strongly interconnected. This correlation is not absolute, but overall when gold prices move higher the AUD/USD will shift to the upside (see Figure 1) and move to the downside together too.

Figure 1: Aussie – Gold Correlation

Australia produced about 10% of the world’s gold in 2015 (see Figure 2) and as mentioned above, there has been a historical relationship between Australia’s currency and the spot price of Gold. Gold and the Australian Dollar have historically been correlated assets, but the correlation has weakened recently, currently being down at 40%.

Figure 2: Gold Production by Country

Pair Trading: The Gold and AUD Trading Strategy

Pairs trading is a popular strategy during periods of low volatility.  With a tight correlation between gold and the Aussie, we establish a Pair Trading Strategy. Pair Trading Strategy is most used in trading equities, but the same principles can be applied to other instruments.  Pair Trading refers to simultaneously buying an asset and selling a related asset at the same time. When volatility is low, it becomes more challenging to place trades that provide profit potential without being purely directional.

A strategy to reduce some of a trader’s directional risk is Pair Trading. Pair trading extends time duration and reduces trade risk, but doesn’t necessarily mean higher probability profit. If the relationship in the pair breaks down, then there may be trading opportunities. If the correlation breaks because the gold price rallies and the Aussie doesn’t follow along, Pair Trading Strategy offers trading opportunities.  This divergence can be exploited by shorting gold (the strongest instrument) and while simultaneously going long on the AUD/USD. Once the value of both the gold and Aussie revert to the statistical mean, a profit will be made.

Trading Example

Looking at the most recent price action, (see Figure 3) since the middle of April and the beginning of May there has been a divergence in the correlation between the Gold and AUD/USD price. While the Aussie topped on April 14th, Gold only peaked on May 2^nd.  With the benefit of hindsight, it is much easier to see the divergences, this could have been spotted the moment Gold hit a new high on May 2^nd, and AUD/USD failed to follow along.  That is the trigger signal for your pair trades.

The ideal trade would be to go short on Gold which is the over-performing instrument, and at the same time, go long on AUD/USD the under-performing instrument. As Gold sinks more than -7.20% or -$94, while the Aussie dropped -5.60% or -430 pips the traders would have made money on the Gold trade and lost money on the AUD/USD trade.   The short Gold trade was a big winner, which generated more than enough profit to absorb the AUD/USD loss and end up with a nice profit.

Figure 3: Gold – AUD/USD Daily Chart

Conclusion

Trading opportunities come from pair trades at a moment when the pairs are not moving perfectly together but are diverging. The underlying premise is that the pairs have historically moved together and will eventually join each other again.