Long Term Outlook For Commodity Currencies

Stepping back from the day-to-day market noise, we remain long-term bulls on the commodity currencies.

Long Term Outlook Commodity Currencies

O ne way to value commodity currencies is to compare their real effective exchange rates against their terms of trade. Despite being near multi-decade highs, the Canadian, Australian and New Zealand dollars are trading at a discount to the levels implied by their terms of trade.

There are many potential sources of upside in the commodity currencies.

First, the current level of commodity prices and terms of trade will drag these currencies higher over time to simply close the undervaluation gaps. The “mean reversion” suggests there is about 10% upside from today’s levels.

Second, assuming that our long term view on commodities is correct, the terms of trade will rise further, placing additional upward pressure on the fair value of the commodity currencies.

Third, there is the potential for overshoots. Canada, Australia and New Zealand are small economies. If global investors (both private and public sector) want to increase their allocation to these relatively small and illiquid currencies, they can very easily overshoot their fundamental values.

Finally, the resource boom will boost domestic incomes and spending, which will force their central banks to keep interest rates relatively high. In a world where the Fed, ECB, BoJ, BoE and SNB have policy rates near zero, investors will be attracted to the higher interest rates in Canada, Australia and New Zealand.

Bottom line: Our Foreign Exchange Strategy service remains a long-term bull on commodity currencies.

Stick With Gold Shares

Gold still has upside, and gold shares could soon play “catch up”.

Stick With Gold Shares

O ur Commodity &  Energy Strategy believes that it is too soon to give up on gold and the same is true for gold shares. Gold miner profits track gold prices and this has not changed in the past few years, although the tracking is far from perfect. What has changed is the traditional 2:1 relationship between changes in gold shares and underlying prices. Global gold shares are flat year-on-year in dollar terms, yet the dollar price of gold is up 22%. This is despite the fact that gold company hedge books are leaner than they have been in years.

One possible explanation is that commodity-sensitive currencies have been strong in recent years. This places a wedge between revenues and costs for many gold producers. Put another way, gold in C$, A$ and SA rand terms has been weaker than in U.S. dollar terms. However, that has not been the case in recent months as the commodity currencies have dropped in the face of investor risk aversion.

A more likely explanation relates to the ETF phenomenon.

Gold company multiple compression accelerated as ETF holdings hit successive new highs in 2010 and 2011. While the divergence is unsustainable, it is difficult to tell when it will end. Even if gold shares are in a bear market versus gold prices, they are stretched relative to the downtrend in place since 2006. P

erhaps global reflation and a softer dollar will spur a “broadening” of interest in lagging liquidity plays, such as gold shares.

Bottom line: Continue to hold strategic positions in gold and gold shares.