A Closer Look At Commodity Currencies

Commodity currencies can be a bellwether for the FX market as they tend to be extremely sensitive to risk sentiment: when risk sentiment is high currencies like the aussie, CAD and NZD tend to rally. In the past these currencies have also performed well when central banks pursue loose monetary policies.

For example, after the Federal Reserve announced QE2 in 2010 AUD/USD rallied more than 13% between October and June 2011. However, since QE3 was announced in September 2012 the aussie’s performance has been lacklustre at best and is up just 1.5%. After a stunning rally since June this year, the CAD has weakened versus the dollar since the announcement of QE3 and has fallen 1% over the past month.

In an attempt to get a greater understanding of commodity prices in the current environment we have taken a closer look at commodity currencies and analysed their correlations with other asset classes.

Here are a couple of interesting observations:
1. The Australian dollar is highly correlated to WTI and the kiwi dollar over the last nine months
2. The Canadian dollar has the strongest correlation with WTI oil but is less correlated with the aussie and the kiwi dollars.
3. The kiwi dollar has a fairly insignificant relationship to WTI, but has a strong correlation (88%) with the Aussie dollar.
4. The Aussie dollar’s correlation with iron ore has broken down in recent weeks, and so has its relationship with domestic interest rate expectations.
5. The correlation between the CAD, AUD, kiwi and the S&P 500 stock index in the US has been consistently strong over the past year. The aussie has tracked the SPX 70% of the time since the start of this year, while for the CAD it is 76% and for the kiwi 65%.

Conclusions we can draw from this analysis:
1. The CAD is moving as one would expect – with the oil price and the SPX (a proxy for the strength of the US economy – Canada’s largest trading partner).
2. Correlations with the Aussie have been less predictable in recent months. After weakening along with domestic interest rate expectations and a decline in the price of iron ore in early summer, these relationships seem to have broken down in recent weeks. Its relationship with the SPX is interesting, suggesting that the aussie could withstand commodity weakness as long as the SPX holds up.
3. The kiwi tends to follow the aussie.

What does this analysis say about the broader markets?
1. After under-performing the CAD and the NZD, the AUD has been making up lost ground since the start of this month.
2. The Thomson Reuters/Jefferies commodity index has retreated from its September peak and remains range bound for now. Commodities have underperformed equities even as US economic data has picked up.
3. The SPX has outperformed the commodity index since June. This tells us a couple of things: 1, US stocks seem to be more sensitive to the improvement in US economic data, while commodities are finding it hard to get direction as China, a major commodity consumer, continues to see its growth rates moderate. While the SPX has reacted well to QE3 from the Fed, the commodity sphere has fared less well. We think commodity prices are poised to rally if China announces more monetary stimulus or loosens monetary policy in response to the slowdown in growth.
4. Commodity currencies are trading in fairly tight ranges, with a mildly bullish bias that seems to be fuelled by the strength in the SPX 500. If commodity prices start to break out to the upside this could precipitate a powerful rally in commodity currencies, until then we expect ranges to persist. In AUD/USD we think this pair is likely to remain between 1.01 -1.06 between now and year end. In NZD/USD we see 0.7900 -0.8300, and in USD/CAD we envisage a range between 0.9600- 0.9950.

Why commodity currencies rely on China
In conclusion, if the aussie, Cad and NZD are to break out to the upside we may need to see commodity prices pick up. For that to happen we believe that China will have to embark on more stimulus in the coming weeks and months. However, although Western central banks are awash in liquidity, China has resisted the urge to turn on the printing presses. If they continue to do this then commodity prices could struggle to rally and this could weigh on the FX market.

Chart 1: Commodity currencies, the CRY and SPX 500 normalised to show how they have performed relative to each other in the past 12 monthsSource: Forex.com and Bloomberg

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