The curious case of the commodity currencies (Part 2)
Why the breakdown in commodity currency dynamics in recent years? And what does this mean for future adjustment?
Part one presented empirical evidence that the CAD, AUD and NZD all saw reliable historical relationships between their terms of trade and their bilateral nominal exchange rate to the US dollar break down in the Brexit/Trump 1.0/Pandemic/Ukraine era.
With conventional linkages weakened or broken in recent years, there is a considerable proportion of 2020s exchange rate levels unexplained by fundamentals. That does not mean that there are no narrative explanations that might close some of that the gap. This is the focus here.
Narrative explanations
The arm wrestle for commodity currency influence
Beyond “big dollar” dynamics, there is a second mega-force that is inescapable in the commodity currency debate: China.
China ascended to the WTO in 2001 and began to call very heavily on the seaborne resources trade from 2002/03, which with hindsight we know was the firing of the starter’s pistol for a half-decade long price spurt seen across all major commodity value chains from 2004-mid 2008.
China remained the primary driver of the commodity cycle in the 2010s, first with its stimulus package coming out of the GFC, secondly with its extended hangover from that phase, thirdly with its “supply side reform” package of 2015-16. And then the other great global force operating on the commodity currency complex – the US policy cycle and its influence on global liquidity conditions – doubled back and intersected with China, through Trade War Mark I, circa 2018.
Styling this another way, it may be appropriate to consider the commodity currency complex as the meat in the sandwich between real economy signals emanating from China (i.e. commodity pricing), and financial signals emanating from the US (i.e. global liquidity conditions proxied by the Fed’s policy stance).
Add the US-China rivalry to the mix, and you have a proximate factor that could be the elusive missing force in the historical debate, where prior to 2016 or so it was assigned an implicit coefficient of zero. A crude attempt to bolt on a dummy variable to capture the era of rivalry in the 2016-2023 sub-sample though met with only minor success. It did not solve the problem of aggregate fit, and there was a near zero-sum relationship with the constant, but it did improve diagnostics on other variables. So, there is something there, but compelling empirical evidence is lacking.
The US energy balance hypothesis
A further theme in this general timeframe is the US’ dramatic uplift in domestic oil and gas production, such that the net impact of oil on the aggregate trade position is much less than in the past, potentially impacting currency dynamics.
The BIS’ Daniel Rees has argued that a rising USD alongside rising commodity prices in the early 2020s was the natural response to an increase in the US’ terms of trade. That is all very well against commodity importers – but why should the USD have gone up in absolute terms against commodity exporters more leveraged to the resources trade than is the US?1
The China bear hypothesis
What could also be happening is that the creeping bearishness attached to the Chinese growth story, with the obvious flow-through to commodities, has encouraged markets to apply large discounts to screen prices due to concerns over their durability, and thus their ability to produce a growth/return premium in the exporting economies worth backing with capital.
These implied discounts would also serve to render risk-adjusted yields in the commodity currencies unattractive if they were not set well above those of the major developed economies. And when relative rates are below the US in absolute terms (a rare but not unprecedented occurrence in ordinary times – but without precedent during a period of high commodity prices), commodity currency central banks (especially the RBA) are essentially sending that pessimistic message to global financial markets: no return premium here. What the RBA got from this strategy was a weak currency, an over-stimulated resources sector, a corporate tax windfall for the central budget, a tighter labour market and a stickier inflation premium than would otherwise have been the case … but that is another story.
The energy transition hypothesis
It could also be that the energy transition is having an impact on how capital is allocated at the margin. Bearish sentiment directed towards commodities leveraged to high-emission activity such as fossil fuel power generation, the internal combustion engine and blast-furnace steelmaking could be eroding the desire to translate increases in these prices into capital allocation decisions.
Weak multiples for listed coal companies despite the enormous surge in prices in 2022 is one example of this possibility. Whether this speculative point also works in reverse, with critical minerals and/or green energy powerhouses achieving some kind of energy transition halo effect, is a watchpoint for future currency dynamics.
Simulating the 2020s under various regime specifications
What would have occurred in FX markets if the historical relationships had held firm through the last few years?
Charts 3.1, 3.2 and 3.3 simulate currency behaviour with actual data from January-2019 to December-2023 applied to coefficients estimated using sub-samples of the 1996-2023 period. For example, the purple line in Chart 3.1 shows the simulated pathway for AUD if the empirical relationships from 1996-2019 had held. Note the 2016-2023 samples are not included as the models are inherently unstable.
The simulations all pick up the 2021 Covid rebound and then the Ukraine supply shock spike and then retreat to levels seen prior to the invasion – but they tend to hold onto most of the 2021 gains. The CAD comes nearest to closing the gap with the actual pathway by the end of the simulation period, the NZD next, with the AUD situation still far resolved. Notably in this regard, both the BOC and the RBNZ have begun to cut rates, while the RBA continues on hold with little sign yet that the Board is ready to waver.
Chart 3.1. AUD/USD actual versus 4 simulated pathways based on model coefficients from the various sub-samples
Chart 3.2. CAD/USD actual versus 4 simulated pathways based on model coefficients from the various sub-samples.
Chart 3.3. NZD/USD actual versus 4 simulated pathways based on model coefficients from the various sub-samples.
Back to the narratives
So where does this leave us?
The discussion has so far unearthed various partial narrative explanations for the curious performance of commodity currencies in the 2020s.
The role of US exceptionalism: bullish sentiment directed towards the US equity market can lead to the USD being seen as a both a safe haven and a growth asset simultaneously, which can lead to a lack of differentiation in the non-USD complex while this endures. Note that the Trump 2.0 America-first policy bundle, which represents a cocktail of inflationary policies that should appreciate the real USD, is out of sample for the modelling described in part one.
Geopolitics: the US-China rivalry is now overt, with the liquidity centre of the global economy in open contest with the locus of physical demand. A crude statistical test of this proposition produced mixed results without a compelling conclusion. We can neither confirm nor deny …
China skepticism: bearish sentiment directed towards the durability of the Chinese growth engine can lead to asymmetric responses to news: significant discounting of good news and confirmation bias on the bad, which would dampen the commodity price to commodity currency link during a price upswing like that of 2021/22. Central banks in commodity jurisdictions allowing their stance to get out of synch with their terms of trade have exacerbated this factor, not leant against it.
Energy transition: bearish sentiment directed towards commodities leveraged to high-emission activity like fossil fuel power generation, internal combustion engines and blast-furnace steelmaking. If this were the case, this should ultimately be captured through the terms of trade proxy as relative prices change. It would also be captured dynamically as export baskets re-weight on the volume side.
Changes in the US energy balance: if there is truth to this, relative commodity baskets will become more of a factor in FX valuations and the “dollar bloc” of the pre “global savings glut” world could be re-established. The return of a dollar bloc would challenge the internal logic of the existing model formulation.
Public sector and national balance sheets were not included in the above discussion, but they have driven FX markets at times in the past and could do so again. Commodity currencies have relatively clean public balance sheets, while the US has been on a remarkable trend of deterioration. (Less commented on in this regard is that US households have stronger balance sheets than the rest of the Anglo-sphere). It is reasonable to surmise that any public sector balance sheet signal will be captured via the interest rate complex, but there could be an argument that a stock measure of liabilities could add further explanatory power to models in future, much as it did in the 1980s and 1990s.
In conclusion: what sort of adjustments may be required for different sets of beliefs?
If you believe in secular regime change:
This would mean that the traditional linkages have been severed and what has been done cannot be undone. In this world, commodity currencies would continue to reflect relative interest rates, but their role as macroeconomic shock absorbers would be reduced and become more erratic. This could increase growth and inflation volatility in these economies, ultimately adding to their risk premium.
If you believe in mean reversion to the old relationships after “pandemic weirdness”:
This is not as simple as it sounds, because there are large level gaps to overcome – reverting to real-time co-movement (roughly one-quarter of commodity volatility translating into FX volatility) will not close those gaps. As the 3x3 in Table 3 describes, there are few benign macroeconomic outcomes here to get back to square one.
Table 3. Example gap closing combinations for the CAD and fundamentals
If you believe the basic linkages will remain influential, but the narrative arguments together carry a cumulative force that commodity currency markets will be different … somehow:
This would mean that AUD, NZD and CAD may be moving into a world where the definition of a set of short-term regimes and the ability to sense when the market is shifting from one to another, becomes a more important skill for an FX trader or strategist than commodity price and interest rate forecasting. If you need any coaching on what that might mean in practice, head across to the gold prop desk.
Huw McKay is a Visiting Fellow at the Crawford School of Public Policy, ANU. His research merges economics, macro-finance, geostrategy, climate, energy and resources, technology and societal trends into a coherent whole. His recent book The Strategic Logic of China’s Economy has been described as “the definitive analysis of the socioeconomic transition of modern China and its precarious journey into the future."
The content in this piece is partly based on proprietary analysis that Exante Data does for institutional clients as part of its full macro strategy and flow analytics services. The content offered here differs significantly from Exante Data’s full service and is less technical as it aims to provide a more medium-term policy relevant perspective. The opinions and analytics expressed in this piece are those of the author alone and may not be those of Exante Data Inc. or Exante Advisors LLC. The content of this piece and the opinions expressed herein are independent of any work Exante Data Inc. or Exante Advisors LLC does and communicates to its clients.
Exante Advisors, LLC & Exante Data, Inc. Disclaimer
Exante Data delivers proprietary data and innovative analytics to investors globally. The vision of exante data is to improve markets strategy via new technologies. We provide reasoned answers to the most difficult markets questions, before the consensus.
This communication is provided for your informational purposes only. In making any investment decision, you must rely on your own examination of the securities and the terms of the offering. The contents of this communication does not constitute legal, tax, investment or other advice, or a recommendation to purchase or sell any particular security. Exante Advisors, LLC, Exante Data, Inc. and their affiliates (together, "Exante") do not warrant that information provided herein is correct, accurate, timely, error-free, or otherwise reliable. EXANTE HEREBY DISCLAIMS ANY WARRANTIES, EXPRESS OR IMPLIED.
Rees’ statistical tests points to structural breaks in the US dollar-terms of trade relationship in Q1-2010 and Q2-2019. Prior to the first break, the US dollar-terms of trade relationship was negatively related. Between the two points, it was neutral. After Q2-2019, the relationship is positively correlated, and of the same absolute value as the negative relationship in the early period.