Commodity currencies

Which currencies the term covers 

A commodity currency is issued by an economy whose export earnings are unusually concentrated in raw materials. The label is descriptive rather than official, and the degree of concentration varies enormously across the currencies it is applied to, which is the first thing to know about the group: it contains currencies whose export base is dominated by a single product and currencies where raw materials are merely the largest of several large categories.

• The Australian dollar. Iron ore, coal, natural gas and industrial metals dominate the export base, and because the largest buyer is China, the currency has functioned for years as a market proxy for Chinese industrial demand as much as for the commodities themselves.
• The New Zealand dollar. Agricultural products, dairy in particular, rather than industrial metals. This gives it a different commodity exposure from Australia's despite the two currencies being read together and traded against each other in AUD/NZD.
• The Canadian dollar. Crude oil is the largest single export, and Canadian production sells at a discount to the United States benchmark, so the currency is read against WTI specifically rather than against oil in general.
• The Norwegian krone. Crude oil and natural gas, read against Brent rather than WTI. Norway's sovereign wealth fund complicates the link, because a substantial share of the export proceeds is invested abroad rather than converted home.
• The South African rand, exposed to platinum, gold and other mined metals, and the Brazilian real, exposed to iron ore, soybeans, coffee and crude. Both are emerging market currencies as well as commodity currencies, and the two labels pull in the same direction during stress.
• The Mexican peso, exposed to crude oil, though its behaviour is dominated by United States growth and by cross-border capital flows to a degree that makes the commodity label a partial description at best.

The mechanism: terms of trade 

The link between a raw material price and a currency is not mysterious and it does not run through sentiment. It runs through the terms of trade, which is the ratio of the prices an economy receives for what it exports to the prices it pays for what it imports. A rise in the price of a dominant export raises national income in foreign currency, and that income has to be converted into the domestic currency to pay domestic wages, taxes and dividends.

A second channel runs through policy. Higher export income tends to raise domestic activity and, eventually, domestic inflation, which the central bank responds to. So the same commodity move that produces a direct conversion flow also produces, on a longer lag, a change in the expected policy rate. The two channels usually point the same way, which is why the relationship is visible at all, and they operate on completely different timescales, which is why it is loose.

The mechanism is symmetric, and this is the half most often left out. A fall in the price of a dominant export reduces income in foreign currency, reduces the conversion flow, and eventually reduces the expected policy rate. Commodity exporters have experienced sustained currency weakness through extended commodity downturns for exactly the reasons that produce strength during upturns.

The dollar problem 

Almost every internationally traded raw material is priced in US dollars, and almost every commodity currency is quoted against the US dollar. That means the dollar sits on both sides of the comparison, and a movement in the dollar alone moves the commodity price and the currency pair at the same time without either economy having changed.

The effect is large enough to manufacture the correlation it is supposed to measure. A weaker dollar raises the dollar price of a commodity mechanically, because the same quantity of the material is now worth more dollars, and it raises the commodity currency against the dollar for the same reason. Someone measuring the relationship between the two would find it, and would be measuring the dollar twice.

Why the link breaks 

A correlation between a currency and a commodity is a statistic measured over a chosen window, and it is unstable in a way that a mechanism is not. Four reasons account for most of the instability, and none of them is unusual.

1. Monetary policy can dominate. When a central bank is moving its policy rate quickly, the rate channel is larger than the terms-of-trade channel, and the currency trades on the rate while its commodity does something else entirely.
2. Risk appetite can dominate. Most commodity currencies are sold during periods of financial stress regardless of what their exports are doing, because they sit on the same side of the risk axis as equities. Since raw materials are usually also sold in such periods, the correlation appears to hold while both are in fact responding to a third thing.
3. The export mix changes. An economy that has diversified, or one whose dominant export has been displaced by another, does not carry the exposure the label assumes. The relationships that gave these currencies their names were measured on export baskets that have since changed composition.
4. Domestic policy can sever the channel. A sovereign fund that invests export proceeds abroad rather than repatriating them removes the conversion flow that the mechanism depends on, and a fiscal rule that saves windfall revenue does the same.

How the group behaves as instruments 

Three of the group, the Australian dollar, the New Zealand dollar and the Canadian dollar, are legs of major pairs and are quoted continuously with substantial depth. The others sit further down the turnover ladder, and the rand and the real in particular carry the wide spreads, thin books and gap behaviour of emerging market currencies.

The hours follow the exporting economy. The Australian and New Zealand dollars are most heavily dealt during the Asia-Pacific session, which is also when the Chinese activity data that most affects the Australian dollar is published. The Canadian dollar is a North American session instrument and is additionally sensitive to the weekly United States crude oil inventory report. The krone is a European session instrument. Depth in each falls away materially outside those windows even though quotation continues.

One structural point applies to all of them. The commodity itself and the currency are different instruments with different depth, different hours and different contract conventions, and a relationship observed between two price series does not mean the two instruments behave alike. The commodity market can be closed while the currency is still quoted, and the currency can gap on an event the commodity market prices only when it reopens.