- Most commodity currencies have underperformed compared to commodity prices over the past two years.
- UBS says this largely reflects widening interest rate differential with the United States.
- It expects that will diminish soon, allowing most commodity currencies to resume their rally.
Commodity prices, from a broad perspective, have enjoyed a good couple of years.
Helped largely by a pickup in the Chinese economy, the largest source of demand globally, they’ve been rallying, and hard in some instances.
As you would expect, that’s also helped to lift commodity currencies over the past couple of years, with the odd exception.
However to UBS the move in commodity currencies, given the scale of the increase in commodity prices, hasn’t been unusually small in scale.
“Despite a 20% rise in commodity prices since March 2016, commodity currency performance has been tepid,” it says.
“Commodity currencies haven’t performed terribly — indeed, within G10 FX, AUD and NZD are the first and third best performers on a total return basis during this time. But given the magnitude of the move in commodity prices, the degree of appreciation appears small.
“Since March 2016, the CRB index is up 20%, and on historical betas, this would suggest that AUD, NZD, CAD, CLP, and NOK should have risen 7.8%, 6.5%, 5.2%, 4.3%, and 1.9%, respectively.
“However, with the exception of CLP, all have underperformed significantly.”
UBS says this performance is unusual, especially as the commodity price rally has been largely synchronised, something it says usually helps commodity currencies to outperform.
Only this time, it hasn’t.
So what gives?
UBS says commodity-bloc currencies have been weighed down by growing interest rate differentials, especially with the United States.
“Although we have argued in the past that rate differentials don’t always drive FX, there are clear reasons to think that they have been an important contributor to commodity currency underperformance,” it says.
“With the exception of NOK, across AUD, NZD, CLP, and CAD, two-year rate differentials have moved in favor of the USD by an average of 160 basis points (bps) during the past two years.”
UBS says that longer-term rate differentials have also been a factor, especially in recent times, with US 10-year yields surging nearly 100bps since September 2017.
“This has been concurrent with the rise in commodity prices, and there is evidence that it has offset the positive impact of rising commodity prices on commodity FX.”
One only has to look at the performance since late January this year to see that stronger commodity prices have done little to help most commodity currencies.
But will the yield-driven headwinds continue to buffer these currencies?
No, the bank believes.
“We expect back-end rates in the US to remain range-bound around current levels,” it says.
“The hiking cycle is well priced, and the Fed’s median long-run neutral rate is now 2.90%. In the current environment of large central bank balance sheets and low, but stable inflation expectations, we expect US bond term premia to remain low.
“Combining our rate expectations and term premium views, we think US long-end rates are close to fair value.”
UBS suggests this should allow commodity prices to increase in importance in terms of valuation.
Along with optimism that stronger US economic growth will help to boost risk assets, UBS expects that commodity currencies, with the exception of the Canadian dollar, will perform well in the period ahead.
“This is positive for commodity FX in two ways,” it says.
“First, it reduces the importance of rate differentials. Even if markets price the additional 10-25bp in hikes in US two-year rates, and commodity central banks continue to lag behind, the impact on commodity FX from rate differentials should be reduced.
“Second, stronger global equity markets driven by better US growth are also more likely to be accompanied by supportive commodity prices.
“Within commodity FX, we favour AUD, NZD, CLP, and NOK, but are bearish CAD.”
Here’s the bank’s latest G10 currency forecasts out to the end of next year.