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Australia has seen its foreign currency exchange rate rise and fall along with the price of its principal exports.

How Commodity Prices Influence the Australian Dollar Exchange Rate, and What It Means for BusinessesARTICLE

Australian businesses trading with other countries — and overseas businesses trading here — have experienced increased exchange rate volatility in recent years1. Globally, there are many reasons for this. But for Australia, one particularly significant phenomenon is the link between the Australian dollar’s exchange rate and the global price of certain commodities, notably iron ore. This article explores that connection for Australian businesses interested to know what influences the exchange rate, and to incorporate that knowledge into their FX risk management strategies.

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 currency’s 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 industries2. When the prices of oil and commodities fall, the currency exchange rates of countries exporting those commodities 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 Australia, along with a handful of other developed countries, also has a commodity currency. Because we’re the world’s largest exporter of iron ore, as the Australian dollar exchange rate floats freely it tends to track the price of iron ore. Similarly, Canada, which is major oil exporters, have commodity currencies which tend to track the oil price4.

How Falling Oil and Commodity Prices Affect the AUD Exchange Rate

In recent years, prices of oil and commodities have fallen precipitously. Iron ore’s price dropped from over US$180 (AU$236) per metric tonne in 2010 to about $40 (AU$52) per metric tonne by the end of 20155. Oil prices influence iron ore prices because the latter usually include shipping costs, so there is also a link between the Australian dollar and the oil price6. The price of crude oil fell from a peak of over $100 per barrel in mid-2014 to $30 per barrel by January 20167. Prices of both oil and commodities recovered somewhat during 2016, though the oil price is now on the slide again as U.S. shale oil production gathers pace8.

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 expansion9. Others, however, pointed to rising production of both oil and commodities due to discovery and extraction of new sources in both developing and, increasingly, developed countries. For example, that shale oil production in the U.S. mentioned above helped to create an oil glut which drove down prices10.

The Australian dollar’s exchange rate has fallen significantly as the price of iron ore and other commodities has declined, and this fall seems set to continue11. But this of course has followed on from a very large rise in its exchange rate over previous years. It would perhaps be more accurate to regard the Australian dollar exchange rate as returning to normal in 2017 after a period during which it was abnormally strong.

Carry Trades Exaggerate the Effect of Oil and Commodity Prices on Exchange Rates

The Australian dollar is not only affected by oil and 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 higher12.

However, as falling commodity prices eliminate yield differences between currencies, these carry trades are unwinding, contributing to exchange rate falls for the Australian dollar. 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 Australian dollars down even more13.

The Takeaway

For Australian businesses involved in import-export trade, the fact that the Australian dollar and certain other 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. Oil and commodity futures prices can be helpful when devising FX hedging strategies, since they indicate a likely direction of travel of oil and commodity spot prices and hence the outlook for the exchange rates of the Australian dollar and other commodity currencies.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1.“Why currency volatility has got worse”, The Economist; http://www.economist.com/blogs/economist-explains/2015/02/economist-explains-2
2. “Dutch Disease: Wealth Managed Unwisely”, International Monetary Fund; http://www.imf.org/external/pubs/ft/fandd/basics/dutch.htm
3. “Commodity Currencies”, Investopedia; http://www.investopedia.com/articles/forex/06/commoditycurrencies.asp
4.“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/
5.“Global iron ore price, FRED database”, St. Louis Federal Reserve; https://fred.stlouisfed.org/series/PIORECRUSDM
6.“Iron ore price drops back below $40”, Mining.com; http://www.mining.com/iron-ore-price-drops-back-below-40/
7. “Global price of WTI crude, FRED database”, St. Louis Federal Reserve; https://fred.stlouisfed.org/series/POILWTIUSDM
8. “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
9.“The End of the Commodity Super Cycle”, Wall Street Daily; https://www.wallstreetdaily.com/2015/09/01/commodity-prices-super-cycle/
10.“Why the commodities super cycle was a myth”, Financial Times; https://www.ft.com/content/e7a9b59e-4caf-11e5-9b5d-89a026fda5c9
11.“Commodity currencies hit by worst oil price slump in a year”, Financial Times; https://www.ft.com/content/262dc811-ce15-307f-9ebc-847e4333a901
12.“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
13.“The Currency Carry Trade: Is It Still Viable”? The Brandes Institute; http://bridgehousecanada.com/knowledge-center/insight-brandes-institute-currency-carry-trade/wppa_open/

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