'Perfect storm' on the horizon for commodity FX
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'Perfect storm' on the horizon for commodity FX

Commodities could be facing further weakness, amid falling demand in China and elsewhere. All eyes are again on the US, where strong growth could support prices and prevent a further sell-off of commodity currencies.

With global growth stuttering, there is increasing concern US plans to raise rates could undermine global growth expectations further, putting downward pressure on commodities.

While the European Central Bank and Bank of Japan have been tipped to keep rates low and even provide their own quantitative-easing stimulus, few believe this will be enough to fuel global growth with the Fed on the sidelines. On Tuesday, Brent crude briefly traded below $87 per barrel, its lowest levels since late 2010. Oil is down some 25% since June.

The outlook for commodities hinges principally on how strong US growth proves to be. “If the US recovery proved itself to be self-sufficient, if there was a surge in US demand, that would certainly help commodity prices,” says Geoffrey Yu, FX strategist at UBS. “US growth of around 4% would be supportive of oil prices.”

However, UBS forecasts growth will fall a little short of this, with 3.2% growth for 2015 and declining quarterly growth rates. 

The Fed seems to be acknowledging these growth concerns with its recent dovish proclamations, designed to prevent the speedily rising dollar choking its recovery. However, while some have suggested rates might stay at current levels for longer than previously predicted, most accept it is a matter of when, not if, rates rise.

“Recent Fed dovishness has limited the downside for commodities, but it hasn’t gone far enough to talk up prices,” says Yu. “It is enough for traders to pull back on their shorts, but not enough for them to go outright long.”

Growing concern

There is growing concern this might prove to be temporary respite – a calm before the storm.

“A perfect storm for commodity currencies seems to be shaping up with the combination of strong dollar and falling global demand likely to keep global commodity prices under pressure,” says Valentin Marinov, head of European G10 FX strategy at Citi.

“Lack of policy stimulus, fiscal or monetary, could mean that things could get worse before they get better for large parts of the global economy.”

Many observers, including Citi, are stopping short of predicting a rout for commodity prices.

“Citi commodity forecasts do not envisage significant changes in G10 commodity terms of trade (CTOT) next year and do not point at significant deterioration in the case of commodity exporters,” says Citi in a research note.

However, predicting commodity prices will hold up might be complacent, especially if USD remains supported, says Marinov. A 10% fall in commodity prices might not be that extreme by historic standards and even a 5% drop would lead to sustained deterioration in CTOT of commodity exporters.

If commodity prices do fall, it will have considerable implications for currencies. In such a scenario, “all commodity exporters, led by AUD and NOK, stand to experience significant CTOT deterioration”, says Citi.

FX commodity 1 

While shorting commodity currencies against the dollar is a popular trade, growing concerns about the commodities outlook is likely to encourage more interest in this trade.

“Hedging needs or alpha-seeking trades have kept options market-making desks busy, pricing AUD downside for the past two years,” says Citi. “Any leg lower in AUDUSD or NZDUSD went hand in hand with higher vols. This time is not different.”

Meanwhile, the sell-off in equities is also clouding oil’s impact in the FX market, says Chris Turner, head of FX strategy at ING. “Typically, Asian currencies, including the JPY, should be the beneficiaries of lower oil prices, as should some of the other large oil importers of South Africa and Turkey,” he says.

However, Turner says central-bank actions are preventing currencies from responding as expected.

“Turkey’s external position should continue to improve on the back of lower energy prices, but more importantly it seems that local policymakers have increasingly taken an interest in preventing TRY falling any further,” he says.

Distorting actions

Even without the distorting actions of central banks, not all “commodity currencies” will be affected equally. Some economies export some commodities while importing others, so a general rise in commodity prices will help some parts of its economy and hurt others. Even if New Zealand, for example, might suffer from weaker agricultural exports, it could benefit from cheaper oil imports.

“Oil price could be a significant macro driver with lower oil prices potentially underpinning domestic demand,” says Citi’s Marinov. With forces pulling the price of oil in opposing directions, the outlook for the oil price looks mixed.

Geopolitical tensions always put upward pressure on prices, especially when they are in the Middle East. Yet with the US increasing its own supply via its shale gas fields, and OPEC so far this year failing to adjust its own supply to keep overall stocks steady, many are predicting further falls.

Whatever it does, the impact it has will vary considerably between economies and currencies. There is a big difference between Canada, for which oil constitutes 25% of exports but other commodities are relatively insignificant, and Norway, for which oil and gas represents around two thirds of exports.

At the same time, while Norway’s economy is dominated by oil, NOK is relatively well insulated from the vagaries of commodity price movements by its large current-account surplus. Hence “NOK is driven more by policy expectations around its planned investment than the actual price of oil”, says Yu at UBS.

Citi adds: “Relatively high policy rates and hawkish expectations make AUD and especially NZD particularly vulnerable.”

Of the two, NZD might be the most vulnerable to further disinflation shock, says Citi. New Zealand inflation has been sensitive to fluctuations in oil prices and, among the G10, the Reserve Bank of New Zealand is the central bank with the highest policy rate and is seen as the most hawkish.

Among the biggest beneficiaries of a general fall in commodities would be JPY, EUR and SEK, says Citi.

FX commodity 2 

Of course, commodities do not have pure correlation and while overall there might be falls, some, such as nickel, lead and platinum, are forecast to rise. According to Rabobank, non-commercial participants have been increasing their net long positions across agri commodities in recent weeks, taking the net long position to 82,816 lots in early October.

For all the talk of precipitous falls in commodity markets, the S&P Agri Index saw a weekly rally of 5.2% in early October, the biggest weekly move since March. Coffee led the gains with a weekly surge of 11.9%. “Managed Money added a further 4,526 lots week on week to their net long position of 43,684 lots,” says Rabobank.

However, trading of these commodities is light compared with the industrial metals and energy products. Their influence on currencies in producer economies is therefore muted, and easily offset by falls in other, more heavily traded commodities.

“Correlations in commodities are high during the initial boom when investors jump on the bandwagon, especially if the rush is caused by a specific event, like a Chinese stimulus package,” says Yu.

“In that case you would have perfect correlation, an assumption by investors that China will buy everything, that is a risk-on trade that lifts all commodities as well as shares, bonds and other assets. But after that initial rush you begin to see more differentiation between the assets that are important to China and those that aren’t.”

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