When a country’s principal export is oil or a commodity, its currency exchange rate tends to track the global price of that export. When the price rises, so does the exchange rate. The rising global price tends to attract inward investment and resources to the extractive industry, while other export industries struggle due to the high exchange rate – a phenomenon known as “Dutch disease,” in which the economy becomes increasingly dependent on its extractive industries.2 When the prices of oil and commodities fall, the currency exchange rates of exporting countries fall in tandem. Currencies that naturally track oil and commodity prices are known as “commodity currencies.3”
Most “commodity currencies” belong to developing countries, many of which attempt to protect themselves from currency exchange rate volatility and Dutch disease by pegging their currency, usually to the U.S. dollar or the euro. But two of the world’s biggest developed countries also have “commodity currencies” – and they both have freely floating exchange rates. Canada is a major oil exporter, and Australia is the world’s largest exporter of iron ore. Their currency exchange rates tend to track, respectively, the price of West Texas Intermediate (WTI) crude oil and the iron ore spot price.4
How Falling Oil and Commodity Prices Affect the Australian and Canadian Exchange Rates
In recent years, prices of oil and commodities have fallen precipitously. The price of WTI crude oil fell from a peak of over $100 per barrel in mid-2014 to $30 per barrel by January 2016.5 Iron ore’s price dropped from over $180 per metric ton in 2010 to about $40 per metric ton by the end of 2015.6 Prices of both oil and commodities recovered somewhat during 2016, but the oil price is now on the slide again as U.S. shale oil production gathers pace.7
The collapse of oil and commodities prices was hailed by some as the end of a “commodities super cycle” driven by voracious demand in China for oil and raw materials to fuel its industrial expansion.8 Others, however, pointed to rising production of both oil and commodities due to discovery and extraction of new sources in developing and, increasingly, developed countries; for example, shale oil production in the U.S. helped to create an oil glut which drove down prices.9
Both Canada and Australia have seen their currency exchange rates fall significantly as the prices of their principal exports declined, and the fall seems set to continue.10 But this of course followed on from a very large rise in their exchange rates over previous years. It would perhaps be more accurate to regard their currency exchange rates as returning to normal levels after a period during which they were abnormally strong.
Carry Trades Exaggerate the Effect of Oil and Commodity Prices on Exchange Rates
The Australian dollar is not only affected by commodity prices, it is also affected by conditions in the Japanese economy. This is because of what is known as a “carry trade.” While the Australian dollar was strong because of demand for the country’s commodities exports, the Japanese yen tended to be weaker because of poor economic performance. Interest rates in Japan were very low, while interest rates in Australia were higher. So, traders would sell yen and invest the proceeds in higher-yielding Australian dollars. This demand for Australian dollars drove the currency even higher.11
There was a similar carry trade between the Canadian dollar and the yen, and also between the Canadian dollar and the U.S. dollar in the aftermath of the 2008 financial crisis, when U.S. interest rates were at historic lows and the U.S. dollar was weak relative to the Canadian dollar.
However, as falling commodity prices eliminate yield differences between currencies, these carry trades are unwinding, contributing to exchange rate falls for Canadian and Australian dollars. Now, reverse carry trades are becoming profitable as oil prices fall and U.S. interest rates start to rise; this will tend to push the currency exchange rates of Canadian and Australian dollars down even more.12
The Takeaway:
For businesses involved in import-export trade with Canada and Australia, the fact that the currencies tend to rise and fall with oil and commodity prices means that FX risk due to currency volatility is an inevitable part of doing business in those countries. Oil and commodity futures prices can be helpful when devising hedging strategies for these currencies, since they indicate a likely direction of travel of oil and commodity spot prices and hence the outlook for the Canadian and Australian dollar exchange rates.
Sources
- “Why currency volatility has got worse,” The Economist; http://www.economist.com/blogs/economist-explains/2015/02/economist-explains-2
- “Dutch Disease: Wealth Managed Unwisely”, International Monetary Fund; http://www.imf.org/external/pubs/ft/fandd/basics/dutch.htm
- “Commodity Currencies”, Investopedia; http://www.investopedia.com/articles/forex/06/commoditycurrencies.asp
- "5 World Currencies That Are Closely Tied To Commodities”, US Global Investors; http://www.usfunds.com/investor-library/frank-talk/5-world-currencies-that-are-closely-tied-to-commodities/
- “Global price of WTI crude,” FRED database, St. Louis Federal Reserve; https://fred.stlouisfed.org/series/POILWTIUSDM
- “Global iron ore price,” FRED database, St. Louis Federal Reserve; https://fred.stlouisfed.org/series/PIORECRUSDM/
- “Oil prices fall as worries over global supply resurface,” MarketWatch; http://www.marketwatch.com/story/oil-prices-fall-as-worries-over-global-supply-resurface-2017-03-27
- “The End of the Commodity Super Cycle,” Wall Street Daily; https://www.wallstreetdaily.com/2015/09/01/commodity-prices-super-cycle/
- “Why the commodities super cycle was a myth”, Financial Times; https://www.ft.com/content/e7a9b59e-4caf-11e5-9b5d-89a026fda5c9
- “Commodity currencies hit by worst oil price slump in a year”, Financial Times; https://www.ft.com/content/262dc811-ce15-307f-9ebc-847e4333a901
- “Is the Carry Trade coming back from the dead?”, The Bull; http://www.thebull.com.au/experts/a/5976-is-the-carry-trade-coming-back-from-the-dead.html
- “The Currency Carry Trade: Is It Still Viable”? The Brandes Institute; http://bridgehousecanada.com/knowledge-center/insight-brandes-institute-currency-carry-trade/wppa_open/
