Under normal circumstances there is a strong correlation between the price of commodities and the strength of a commodity-linked currency. As we have previously reported, when crude oil prices weakened in late 2018 the Australian and Canadian dollars both experienced double digit falls.
But a JPMorgan research note published on May 7 pointed to a significant decoupling of commodity FX (based on a basket of currencies that includes AUD, NZD, CAD, NOK, BRL, RUB, ZAR, CLP, COP, PEN, and MXN) from commodity prices this year. The authors observed that several commodity currencies are now screening cheap relative to commodities and that their typical correlation is unlikely to return anytime soon.
However, Adam Button, chief currency analyst at ForexLive, reckons there is no better place to be in the current phase of the economic cycle. “There is an abundance of disbelief in both commodities and commodity currencies, but that kind of scepticism is usually a sign that a bull market has a long way to run,” he says.
“It is exactly what you would expect coming out of a pandemic and with so much uncertainty in the world, although some of it also reflects bottlenecks and a reluctance to embrace the post-pandemic boom. The true tipping point will be late this year when OPEC+ space capacity is exhausted and oil begins to run.”
The commodity super-cycle has been running wild all year, but that doesn’t mean there isn’t a chance for meaningful returns with some commodity-linked currencies. That is the view of Oanda senior market analyst Ed Moya, who refers to the Mexican peso as a favourable trade on the basis that it will benefit from the strength of the US economic recovery, a better Covid vaccine roll-out than the rest of Latin America and exposure to a wide range of commodities prices that will likely remain intact due to supply shortages.
“Coronavirus has complicated the link between commodity prices and their respective linked currencies,” he says. “In order for a commodity-linked currency to rally, the respective country needs to have Covid cases under control, a decent handle on its budget and political stability.”
BNP Paribas is bullish on commodity-linked currencies and forecasts broad based appreciation against the US dollar from now through to the end of 2021. According to Sam Lynton-Brown, the bank’s deputy head of global macro research and head of G10 FX strategy Europe, one reason for commodity price rises outpacing commodity exporter currency performance is that as commodity prices rose in the first quarter so did expectations of Federal Reserve tightening – and this supported the dollar to a greater extent than is typically expected during periods of ‘risk on’.
“Looking ahead, because the scope for a significant further adjustment higher in US yields is more limited than it was in Q1, commodity currencies may exhibit a more stable relationship with commodity prices,” he adds. “On the emerging markets side, the recent disconnect was much less visible as strong external accounts continue to support commodity currencies, along with rate hike expectations.”
In central and eastern Europe, Middle East, Africa (CEEMEA) and Latin America, Deutsche Bank is neutral on both the Chilean peso and South African rand, which have been the two best performing commodity currencies this year.
“Positioning in those two currencies is somewhat long and there are idiosyncratic factors (negative outcome of Chilean constitutional assembly elections, rising Covid cases in South Africa) that make me cautious,” says Deutsche Bank macro strategist Oliver Harvey.
The bank is more bullish on the Brazilian real, which is heavily disconnected from iron ore and gas prices where valuations are cheap and where terms of trade are feeding into a strong basic balance surplus, as they did for South Africa and Chile in the final quarter of last year.
Deutsche Bank analyst Michael Hsueh refers to a positive view of the Australian dollar given the durability of the commodity rally in industrial metals and iron ore, as well as a current account surplus and an AUD discount in comparison to mining stock outperformance.
“On CAD we remain positive given the more responsive Bank of Canada reaction function and tailwind from US stimulus but circumspect as it is now more fairly priced,” he adds. “On NOK we are least positive, seeing the long trade as done as the hiking cycle is fully priced, while it is at risk of weaker foreign inflows and fiscal tightening past September.”
JPMorgan’s research note stated that commodity FX was not an attractive inflation hedge. Button disagrees, however, suggesting that commodity currencies offer the best inflation hedge aside from the commodities themselves. He describes CAD and the Mexican peso as being particularly well positioned in this cycle because of their diverse commodity mix and proximity to the US.
“In general, I favour developed market commodity currencies and emerging market commodity exporters with strong, stable governments because food price inflation can be particularly destabilizing in the developing world, though I don’t yet anticipate that being a problem in 2021,” he adds. “For CAD, the main risk is a housing correction, but I can’t see that happening at the same time as a commodity boom unless the Bank of Canada gets particularly aggressive.”
Canada will also benefit from higher precious metals, lumber and plastic prices. The Bank of Canada was the first major central bank to taper its asset purchases and will likely be one of the first to raise interest rates; and the improving interest rate differential should keep the loonie supported throughout the rest of the year.
Burak Baskurt, BNP Paribas CEEMEA strategist, reckons commodity-linked currencies provide a particularly appealing hedge when funded out of low beta FX. “In emerging markets, monetary policies will react earlier to rising inflation risks compared to developed markets so rising interest differentials can support emerging market currencies, especially commodity exporters that also enjoy strong external accounts,” he says.
