Making sense of market correlation

Written by Benjamin Girard on Jul 18 2018

Another piece of the grain marketing puzzle

In grain markets, the term correlation refers to how two assets such as stocks or commodities move in relation to each other. Two commodities that move up or down together (even if not perfectly) are considered positively correlated, and two commodities that usually move in opposite directions are negatively correlated.

I once tried to explain the difference between positive and negative correlation to a client. Within minutes, he said he understood perfectly. “It means that when oil prices go up, gas prices at the pump go up. That’s positive correlation,” he said.  “When oil prices come back down, gas prices keep going up and that’s negative correlation.”

That’s difficult logic to argue with, but all joking aside, the relationship between crude oil and the Canadian dollar is an example of positive correlation. When you look at the long term, a rising crude oil price tends to happen at the same time as a rising Canadian dollar. There are several reasons for this, and the most common is that the Canadian market supplies large amounts of crude oil. This drives increased purchases of Canadian dollars when oil prices are high as oil sales transacted in US dollars are converted back to our currency. Additionally, a hot crude oil market often brings heavy investment into Canadian energy companies from international markets, which means these investors need to purchase Canadian dollars.

It is important to recognize that although the Canadian dollar and oil are positively correlated, they won’t necessarily move in the same direction every day. It simply means they will often, over the long term, move in the same direction.

An example of negative correlation would be the relationship between wheat basis and the Canadian dollar. When the dollar falls, the wheat price (in US dollar terms) is converted back into our currency at the lower exchange rate. This “extra” money that was gained from the exchange can then be added in to the basis levels that we see at the elevator.

Correlations are also not a perfect 1:1 ratio and will affect markets in different ways. For example, a falling Canadian dollar may benefit wheat prices (through the basis), to a greater extent than it will benefit canola prices (through our product becoming cheaper to world markets). However, these relationships still suggest that in Canada, both wheat basis and canola futures are negatively correlated to the Canadian dollar.

Other correlations:

  •   Soybean Oil vs Canola - Positive
  •   Corn vs Chicago Wheat – Positive
  •   Chicago/Kansas/Minn Wheat – Positive
  •   US Dollar vs Canadian Dollar - Negative
  •   US Dollar vs Grain Futures – Negative

As world economies and markets become more connected, and more dependent on each other, it is becoming more and more noticeable how these markets are positively and negatively correlated to each other. Understanding how these markets are correlated can help you make more sense out of seemingly random moves in the markets. When it comes time to make a grain marketing decision this is a valuable type of analysis that can be used to evaluate risks on your grain and help you to select the right marketing tools.

Tags: Grain marketing, Futures, Wheat

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