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Commodity currencies caught between risk and return

Rising commodity prices are currently driving up the foreign exchange markets: benefiting from this are the currencies of commodity-rich countries such as Norway, South Africa and Canada. Exchange rates are rising, as are the prices for oil, copper and iron. On the investor side, this raises the question of how this momentum can be carried forward and which currencies can offer attractive returns in this type of scenario.

“Currencies of countries whose exports, and therefore economic growth, are particularly dependent on natural resources or the export of a specific commodity are typically referred to as ‘commodity currencies’,” says Andrea Siviero, Investment Strategist. For those countries, it is common for their currencies to be highly correlated with the performance of the domestic extractive industry or with the price of the commodity in question, he says. “Currencies typically considered commodity currencies include the Norwegian krone, the South African rand, the Russian rouble, the Chilean peso, the Canadian dollar, the New Zealand dollar and the Australian dollar. For investors, investing in these or other foreign currencies always means taking on a certain exchange rate risk and should be considered carefully.”

While commodities themselves are usually priced in US dollars, commodity currencies typically move with the international price of natural resources, as a large part of the country's economy is based on the production and export of this commodity. “An increase in the price of the relevant commodity translates into both higher revenues and growth rates in the exporting country and, as such, usually leads to an improvement in the country's current account balance,” the expert says. “Commodity currencies generally offer higher interest rates, as commodity exporters usually exhibit higher growth rates than those countries with safe haven currencies. This is particularly relevant for emerging economies.” Investing in commodity currencies can be particularly interesting if the commodity currency is expected to appreciate against the domestic currency, he says. “This is particularly the case during periods of economic growth and strong commodity demand, as the price of commodities increases and the respective commodity currencies appreciate against the traditional safe haven currencies.”

Pitfalls in the investment decision

The current phase of economic reflation coupled with strong economic recovery and rising commodity demand could therefore appear favourable for investments in commodity currencies. “However, there are some pitfalls to be aware of and avoid,” Siviero explains. “While emerging market commodity currencies generally offer higher interest rates, their overall performance can suffer from higher inflation rates, and social and geopolitical issues. In addition, investing in these currencies sometimes carries operational risks and higher costs.” Furthermore, commodity currencies tend to have above-average volatility and price assessment is also challenging, as commodity prices are determined not only by physical demand and supply dynamics, but also by the price of the financial assets linked to the commodities.

Caution is also called for when assessing seemingly favourable investment situations: “Investing in commodity currencies during the current low interest rate environment, high economic growth and risk-on markets may be attractive at the moment,” says Siviero. “But the current macroeconomic situation can change at any time. A tightening of monetary policy in the advanced economies, China's crackdown on commodity speculation or an economic slowdown could trigger a correction in commodity currency prices.”

Investment alternatives with different risk profiles

There are several factors to consider when investing in commodity currencies. “To build up a position in commodity currencies, a sound analysis of the macroeconomic and geopolitical situation of the commodity exporter is key,” explains the economist. The rise in commodity prices is not a guarantee per se that the respective currency will continue to appreciate, or even maintain its current value. If the risk profile of commodity currencies of emerging economies is too pronounced, it could also be an alternative to invest in commodity currencies of advanced economies, which will probably offer lower interest rates but are likely to be less volatile. “In terms of risk profiles, a middle ground is also possible: if investing in commodity currencies themselves seems too risky or operationally complicated, equity investments in international companies that produce and export the relevant commodities can be used to gain exposure to the commodity market,” says Siviero. “But in the end, all investment strategies have one thing in common: the right timing is crucial.”