Commodity Dollars

What Are Commodity Dollars?

The term "commodity dollar" is used to define a currency closely correlated with raw materials integral to a nation's export sector. Also referred to as a "commodity currency" or "comdoll," commodity dollars derive a great deal of their value from specific underlying assets. The markets of oil, gold and agricultural products often play key roles in the exchange rate valuations of these currencies.

Generally speaking, the money of emerging economies relies heavily on the pricing of domestic raw materials. However, developed nations such as Canada, Australia and New Zealand are the world's leading commodity dollars. Their currencies play a key role on the forex and represent three of the seven major pairings (AUD/USD, USD/CAD, NZD/USD).

Commodity Dollars: Pricing And Valuation

Commodity dollars feature a valuation model that is distinct from those of other currencies. In addition to central banking policies, economic cycle and geopolitical concerns, the export sector's performance is an especially important factor in exchange rate pricing.

Due to the nature of commodity exports, the prevailing market values of raw material cargoes are primary drivers of sectoral performance. Pricing these products is a complex undertaking that incorporates many factors, including global supply and demand. Accordingly, the process of commodity price discovery is conducted on two primary types of market:

• Spot: Spot markets are venues where securities or raw materials are traded, with transactions being executed with immediate delivery in mind. Also known as "cash markets," they facilitate the exchange of physical goods for hard currency.
• Derivatives: Futures, options and forwards deal with the pending purchase or sale of an underlying asset at a forthcoming point in time. As related to commodities, they may be used to secure physical delivery of raw materials, for speculation or to hedge producer/financial risk. The global futures and options markets are immense and account for an annual traded volume of more than 30 billion contracts.^[1]

The traditional relationship between supply, demand and scarcity is the largest underpinning of commodity valuations. However, many other factors frequently intervene in pricing:

• Governmental Regulation: Environmental protections, subsidized production and industrial regulations are all capable of skewing the cultivation of commodities. Subsequently, prices can be significantly impacted.
• Geopolitical Conflict: Tariffs, economic protectionism and armed conflict periodically influence the commodity markets. In the event a war or trade war breaks out, the pricing of raw materials often reacts violently.
• Producer Hedging: Large-scale risk management practices regularly impact the prices of raw goods. Institutional investors, governments, central banks and producers have been known to stockpile certain goods as insurance against systemic risk(s).

Uncertainty stemming from enhanced regulations or evolving geopolitics can turn commodity markets upside down. In addition, hedging practices incorporating futures and options can sway the prices of related derivatives products. The turbulence routinely spills over into the currency markets, influencing the exchange rate valuations of related comdolls.

Global Majors

Although typically relegated to emerging markets, commodity dollars enjoy a prominent standing among the global majors. In fact, the Australian dollar (AUD), Canadian dollar (CAD) and New Zealand dollar (NZD) are three currencies that exhibit a sensitivity to the pricing of raw materials. Accordingly, the major pairings of the AUD/USD, USD/CAD and NZD/USD are viewed as being the primary comdoll offerings on the forex.

Traders and investors frequently look to the major commodity currencies for speculative opportunities and as tools for hedging risk. Below is a quick look at the drivers and functionality of these securities:

AUD/USD

The Australian dollar features a keen sensitivity to gold pricing. As of year-end 2017, Australia ranked behind China as the second-largest global gold producer (295.1 metric tons). Led by bullion, the minerals industry accounts for more than half of Australia's exports and about 8% of its gross domestic product (GDP).^[2] During the Global Financial Crisis of 2008-12, the AUD reached all-time highs against the USD due to a sharp appreciation in gold price. At the peak of the crisis (July 2011), the AUD/USD hit all-time highs at 1.1080, greatly benefiting from international demand of the safe-haven asset.

USD/CAD

Known as the "Loonie," the Canadian dollar has exhibited a historical sensitivity to the pricing of crude oil and natural gas. Fossil fuel exploration, extraction and exportation play an integral role in the energy-dependent Canadian economy. According to the Energy Information Association, Canada ranked fourth globally in oil production for 2018, generating 5.27 million barrels per day. This output measured 5% of total world production,^[3] with fossil fuels measuring more than 7% of Canadian GDP.^[4] In terms of correlations, the USD/CAD has shown a historical relationship to that of West Texas Intermediate (WTI) crude oil. Upon WTI crude oil posting an all-time high of US$145.27 per barrel in July of 2008,^[5], the Canadian dollar traded below par value (1.0000) with the USD. As WTI crude plunged from this level by more than 70% in under six months, the USD/CAD quickly rallied north of 1.3000.

NZD/USD

In comparison to the CAD and AUD, the New Zealand dollar is not heavily correlated to a single commodity such as gold or oil. The NZD exhibits periodic sensitivities to various agricultural products such as dairy and beef. Due to its standing as a smaller island nation, there is an extra impetus upon the export sector, specifically raw goods, to facilitate economic growth. As of 2017, the export sector accounted for 26.9% of annual GDP.^[6] During the plunge in commodity prices during the second half of 2008, the NZD was devalued extensively against the USD. For the six-month period from 1 June 2008 to 1 December 2008, the NZD/USD fell from .7833 to .5202, a loss of about 34%.

Emerging Economies

While not universally viewed as being official forex commodity dollars, the currency exchange rates of emerging economies frequently rely on the pricing of local raw materials. These monies exhibit a special sensitivity to the international value of domestic goods and can experience extreme periodic volatility. The lack of industrial capabilities and a reliance on exports leads to various currency/commodity correlations.

In most cases, the currencies of emerging economies are classified as "exotics." Below are a few that are interrelated with regional commodity production and exportation:

• South African Rand (ZAR): As of year-end 2017, South Africa ranked eighth in the world in gold production.^[7] The minerals industry, specifically gold and diamonds, plays a large role in South Africa's economic well being and the ZAR's value.
• Thailand Baht (THB): Thailand is the world's largest exporter of rice and a top ten rice-producing nation.^[8] Global surpluses or scarcity of rice can drive exchange rates of the THB directionally.
• Brazilian Real (BRL): Although ranking globally as an economic power in terms of GDP, Brazil is still considered to be a developing nation. As a result, the BRL relies on the international pricing of commodity exports, specifically soybeans.

One of the leading challenges facing developing economies and their currencies is a phenomenon known as "dutch disease." Dutch disease refers to the tendency of an emerging nation's currency to dramatically appreciate in value due to a spike in commodity pricing. The long-term ramifications are largely negative and led by lagging economic growth and rising unemployment due to labor outsourcing.

Summary

For active forex participants, commodity dollars often play a key role in portfolio design. Retail and institutional traders alike engage these instruments in an attempt to secure marketshare via speculation or wealth preservation.

The AUD, CAD, NZD and the currencies of select emerging economies furnish forex traders with a collection of unique opportunities. However, trading these instruments requires extra due diligence. To engage the comdolls, you must take into account national economic performance in relation to exports and related raw material pricing.