Market Directions Sunday March 30, 2008
The Commodity Currencies
Two of the Asian Dollars, the Australian and the New Zealand and one of the North American, the Canadian, are the currencies of best know and largest of the world’s natural resource based economies. These currencies have tended to rise and fall with the commodity use cycles of global economic growth. In the past, as the industrial world economic growth waxed and waned these currencies would move higher and lower anticipating the state of world commodity usage six months to a year in the future. As the economic growth cycle reached it peak the currencies would decline with the pending drop in economic productivity, anticipating also the central bank rate cycle. In the past, growth cycles were relatively well coordinated across the western industrial world and Japan, with the United States acting as the engine for worldwide economic activity.
Into this simpler world of industrial consumers and resource producers, twinned in economic cycles, has entered the developing world, and the newly industrialized nations of Asia, foremost India and China.
These countries constitute a resource market independent of the older industrial countries. With very large populations and burgeoning consumer classes, they have continued their breakneck economic growth ignoring, so far, the slowdown in the United States. Their internal markets for consumer goods, many of them of their own production, have also grown apace. Their rapid ascent as large resource consumers has outstripped the development of new sources for commodity production. One result has been the commodity price boom, led by the most ubiquitous of all industrial commodities, oil. Resource extractions economies and their currencies have benefited with strong GDP growth and buoyant currencies.
But the situation is about to change. The American economy has stalled, it may have already entered recession, the length and depth of which is unknown. To date there have been few signs of a sympathetic slowdown in Europe, China or India. But some degree of spillover from the United States is still an assumption the currency markets cannot discount.
Will the commodity currencies, dependant as their economies are on resource exports, maintain their current high levels in the face of this potential economic slowdown? What other factors have contributed to the long sustained run in these currencies?
All three currencies have been at or near historic highs against the US Dollar in the past several months. The worldwide commodity boom and the weakness of the US currency have provided much support. But equally important for the two Asian Dollars have been the activist anti inflation policies of their central banks. The base rates in New Zealand and Australia, 8.25% and 7.25% respectively, are some of the highest in the world. But, as with global economic growth change is looming.
The Reserve Bank of New Zealand has not altered rates since last summer and recently moved to a neutral stance. The Australian Central Bank added 25 basis points in March and retains a tightening bias. But as the only major industrial bank still raising rates it is doubtful the policy will continue much longer. As with the ECB, the next move, at whatever timing, will likely be lower. The present rate hike cycle appears to be over. Canada with its much closer ties to the American economy has already begun its rate reductions. The support that had been provided to these currencies by the widening rate differentials will probably begin to reverse over the next months.
The last support factor for these currencies has been the extraordinary speculative run in the so called ‘carry trade'. But that too has been severely diminished in the past six months.
The New Zealand Dollar/Japanese Yen cross peaked at 97.75 last July. At its current level of 79.00 it is almost 20% below the top. Since the massive risk aversion drop in August of last year the currency pair has exhibited a steady if volatile downtrend. Much the same can be said of the Australian Dollar/Japanese Yen cross. It peaked in July at 107.50, fell precipitously at onset of the credit crisis in August, climbed again to 107.85 in late October on strength in the Australian Dollar and has since moved steadily if chaotically down to its current level of 91.00, 16% below the summit. Likewise the Canadian Dollar/Japanese Yen pair reached 125.50 early last November and is now languishing near 97.00, a 22% decline.
A good portion of the weakness in these crosses is attributable to the fall in the US dollar component of the crosses -- the dollar yen -- as the rate of the US dollar against the yen is called by traders. The cross rate for two of these pairs is obtained by multiplying the dollar yen rate by the rate for the Australian the New Zealand Dollar. But the driving force down has been the sustained aversion to speculative risk that has overtaken the currency markets since the beginning of the credit crisis last August.
The steady support these speculative crosses supplied to the non yen component, the Australian Canadian and New Zealand Dollar, as the crosses moved ever higher has been lost. And a return of the dollar yen component, that is a rise in the US Dollar against the yen will not bring these crosses back. Any gain to the cross will likely be balanced by losses in the opposite component; as the US Dollar moves higher the three other dollars will sink; the cross rate will not gain. In other words if the US dollar strengthens then the Australian New Zealand and Canadian Dollar will weaken and the carry trade crosses will continue to fall.
Of the three factors that have contributed to the long bull market in these commodity currencies only one, the demand and price for their resource exports is likely to remain at elevated levels. With the increasing worldwide demand commodity prices will not return to pre boom levels as would normally happen at the end of an expansionary economic cycle. Until high prices bring development of new sources for commodities or substitutes to market, commodity prices are likely to remain above historical norms.
The two remaining factors, the rate advantage over the US dollar and the structural support provided by the rising carry trade to the cross rate and its components have already moved to neutral, the rate advantage, or reversed, the carry trade. Neither will give the commodity currencies any further extraordinary support.
Prediction is risky, but it is likely that all three commodity currencies have peaked and will over the next year revert to more historical levels.
Joseph Trevisani
FX Solutions
Chief Market Analyst
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