Commodity Currency



Have you heard the term Commodity Currency?

You know what currencies are.

And you know what commodities are.

But that term... aren’t currencies a type of commodity?

This can get confusing…

Let’s clear all those doubts and more. Read on.

What’s a Commodity Currency?

A commodity currency is a type of currency whose price often goes hand in hand with commodity prices (and demand/supply of said commodity, see below).

But why? And which commodities?

It all comes down to the issuing economy.

Many economies around the world are export-oriented.

Exports rock! I’m so lame…

This means a good chunk of Gross Domestic Product (their income, or production) comes from selling their natural resources to other countries.

How does this happen?

Think about it this way: a country, (say) Venezuela, is fortunate enough to have many oil deposits it can extract and commercialize.

In fact, it has so much, its own domestic consumption can’t absorb all of the oil being produced.

So what does Venezuela do?

Well, fortunately, there was another country, (say) Dominican Republic which has an abundance of natural resources, but no big oil reserves within its borders.

Turns out Dominican Republic would be interested in buying (importing) some of Venezuela’s oil.

When too much of a good thing IS a good thing.

When the two countries conduct the transaction, we say Venezuela exported oil, while Dominican Republic imported said commodity.

Since Venezuela’s production and exports of oil represent a good chunk of the country’s income, we can say they depend on oil for their livelihood.

There’s a problem though…

Commodities, unlike more elaborate goods, can’t command a price premium on the market.

Why? Because no matter who provides it, it is always the same basic product (no differentiation).

To top things off, commodities tend to be abundant and spread around the world, which means many producers can offer said product in the market.

This means commodity producers have to take market prices.

If they choose not to sell, someone else will provide the product (just look at how difficult it is for OPEC to secure production cuts within its member nations).

And in this globalized economy, with centralized commodity futures markets standardizing prices further, we get the following result:

An economy like Venezuela’s can’t do much about international oil price (or demand, or supply), therefore, it is at the whim of the markets.

Governments build Sovereign Wealth Funds in good times, so they can fund the budget in a commodity downturn.

Since the economy goes up and down with the fate of oil, sudden price moves affect the economy directly and quickly.

And since an economy’s well-being is linked to its currency, shocks in commodity markets affect the currency in question.

Even more directly, demand for the Venezuelan Bolivar (their currency) would go down if oil demand drops (they no longer need it to purchase)

Note: as I’ve said in other pieces, this type of international transaction often happens in USD, however, said Dollars are often changed back to the domestic currency of the exporting country, thus increasing its demand.

End of note.

This link between currency and commodity prices is why we call them commodity currencies.

Which Majors are Commodity Currencies?

So, you might think only a small, open economy would have a commodity currency since big, developed economies tend to be more diversified.

And for the most part, you would be right.

Many small, developing countries are known for a particular commodity they export (hence, their currency is a commodity currency).

But the truth is:

Many developed economies also have commodity currencies.

Following the example of oil as an important export, think of Canada.

Great country, great economy, great commodity currency.

Canada is the tenth biggest economy in the world. Producing 1.5 trillion USD a year (2016, IMF data).

And yet, the Canadian Dollar (CAD), the currency of Canada, is a commodity currency.

Since exports of oil account for (roughly) 8% of GDP, movements in oil markets often reflect themselves in the CAD exchange rate vs other majors.

But let’s give you what you asked for.

The three most important commodity currencies in FX markets are:

1.    The Canadian Dollar (CAD), which shifts with oil markets.

2.    Australian Dollar (AUD), which shifts with iron ore (among others)

3. New Zealand Dollar (NZD), which varies with its commodities, especially milk powder and dairy exports.

Got milk? Yes, the New Zealand Dollar can move with happenings in the Cow industry. I have to try that milk sometime, it must be good.

These are the three most important because they’re part of the eight majors.

Why?

Because of the soundness of their issuing economies, and the trust global investors have on them (and their regulating bodies, Central Banks).

For these reasons, these commodity currencies, along with the other majors, hold the highest liquidity (you’re more likely to fill thy orders) and smaller spreads (screw thy broker).

How To Trade a Commodity Currency

Time for the meat and potatoes.

Price of a commodity currency doesn’t always go hand in hand with going-ons in commodity markets.

This is often the case when:

1.    Moves in commodity markets aren’t that big a deal (moves of such magnitude happen fairly often); or

2.    Something more important is going on at the time.

My first point, I believe, it’s pretty self-explanatory.

Let’s elaborate for the second.

Imagine oil price is shitty today, and it lost double its usual daily range for some reason (assume this move is strong, but it happens once or twice a week).

CAD would go down right?

What if the Bank of Canada (BoC) just surprised the markets with a rate hike (and plans to do hike again soon)?

That’s right.

In this case, no one will pay attention to oil.

CAD will go up like gangbusters.

Unexpected rate hike = Currency goes up, up, and uuuuuup.

This is because monetary policy (interest rates) is a much more powerful mover of currency price than any other thing (barring a huge even like the Great Recession in the US, for example).

Similarly, other market happenings may be grabbing the headlines at the time, and eclipsing oil’s effect on CAD.

Of course, if both events cause CAD to move in the same direction… (You got a high probability trade, assuming you find a good currency to pair CAD with).

Ok, so how do I know commodity markets are affecting a currency?

Check the news feeds.

I’ve said over and over.

Instead of trying to divine it yourself, just check posts from FX analysts on Forex news sites and news feeds.

They will tell you when commodity markets are shaking a currency. This way it’s less likely you’ll commit a mistake.

But won’t that be too late to cash in?

Not really. At least not if you’re checking the feeds first thing in the morning (just before a session starts) or at a session break, and the move is fresh.

That’s all on this topic for now.

See you soon,

Emil Christopher,

The Forex Economist

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