FX Watch – Weak outlook for Commo FX

by: Georgette Boele , Roy Teo

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We remain negative on commodity currencies. Although we expect commodity prices to bottom out and some to rise, the sharp correction in prices will have a lasting impact on the economies of commodity exporters and their currencies. In addition, a higher US dollar, US Fed tightening and in general weak fundamentals also add pressure. We assess the Australian dollar, New Zealand dollar, Norwegian krone, South African rand, Brazilian real and Central American currencies to be among the most vulnerable currencies. However, we expect the Canadian dollar and Chilean peso to do relatively well.

Since the peak in June 2014 commodities and related currencies have shown large losses

Since the peak in June 2014, commodity prices have fallen sharply. The CRB index has declined by 30% since the peak set in June 2014. The massive drop in oil prices was mainly responsible for this, because it has the largest share in the CRB index. An outlook of oversupply, lower risk premium and fears about energy demand pushed crude oil prices lower. In addition, weakness in copper, gold and soybean prices also contributed to the negative performance of the CRB index.

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The 30% drop in the CRB index since July 2014 has coincided with a 22% rally in our USD/Commodity currency index (weakening of commodity currencies, see graph above). Our USD/Oil currencies sub index rose by 53% (currencies of oil producers heavily underperforming) when oil prices dropped by 56%.

Stronger global growth to support cyclical commodities…

Lower oil prices will push up economic growth and this is supportive for commodity demand. We expect fundamentals for cyclical commodities to improve, leading to a recovery in oil, most base and precious metal prices (excluding gold, see our Commodity Quarterly Outlook). This will happen once investors have cleared a substantial part of their positions. However, the recovery of some of the cyclical commodity prices will unlikely be strong enough to overcome the other negative forces for commodity currencies going forward.

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…but headwinds for commodity currencies remain

Although we expect commodity prices to bottom out and some to rise, the sharp correction in prices will have a lasting impact on the economies of commodity exporters and their currencies. Most commodity driven economies are currently adapting to the new reality that the commodity super cycle is over. For example, Australia has made significant efforts to rebalance the economy away from commodity exports. Despite these efforts, more needs to be done. It is likely that economic growth will remain below trend and monetary policy will remain accommodative unless inflation is a serious problem. Brazil is an example of the latter.

In addition, we expect a strong US dollar across the board driven by outstanding US economic growth and rate hikes by the Fed. There are very few central banks that will move into the direction of tightening monetary policy and some are in easing mode. The US will be tightening, because of the strength of the US economy.  This makes US assets attractive to foreign investors. As a result, investor’s flows will move towards the US and this hurts other currencies.

Moreover, higher US interest rates could coincide with a general deterioration in investor sentiment of emerging market and growth sensitive currencies. Sharp weakness in emerging market currencies could result in central banks defending their currency.

What currencies will be most and least vulnerable?

The AUD to be the weakest major commodity FX

Among the major commodity currencies, we are most bearish on the Australian dollar (AUD) for the following reasons. First, we expect the economic outlook to deteriorate and the rebalancing of the economy to take longer. The slowdown in China is also going to weigh on the Australian economy.

Second, we expect the Reserve Bank of Australia to cut interest rates by 50bp in the first half of this year. This is sooner than what is priced in by financial markets. We no longer expect the speculative activities in the housing market to withhold the RBA from cutting rates, because tougher regulations on bank lending practices and other macro prudential tools can tackle this. We have lowered our 2015 year end AUD/USD forecasts from 0.74 to 0.72.

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The Australian dollar is also more vulnerable to reversal of capital flows given the magnitude of maturing corporate and government bonds held by foreign investors in the next two years. Last but not least, with fiscal stimulus likely to be limited given lower government tax revenues, we judge that further monetary stimulus is essential to stimulate the rebalancing of the economy.

… followed by the New Zealand dollar

The New Zealand dollar (NZD) is vulnerable due to its expensive valuation and the policy of the central bank to weaken the currency. The relatively strong domestic economy and high interest rates in the NZD have resulted in the exchange rate trading higher than the central bank’s comfort level. We have lowered our NZD/USD forecasts as we suspect that the Reserve Bank of New Zealand will continue their intervention policy to weaken the NZD. In addition, diverging monetary policy between the US and New Zealand should push NZD/USD lower.  We now expect the NZD/USD to head lower towards 0.68 by the end of this year compared to our previous forecast of 0.71.

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…and the Norwegian krone…

The sell-off in oil prices has not filtered through to the economy yet, but weakness in the Norwegian krone has been pronounced. We expect the Norges Bank to continue to ease monetary policy to dampen the impact of the low oil prices on the economy. Weaker economic growth and more monetary policy easing will keep the Norwegian krone under pressure versus the US dollar.

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Weak fundamentals also to hurt emerging market commodity currencies

Emerging market commodity currencies are highly sensitive to changes in overall investor sentiment, the US dollar and the global economic outlook. We remain positive on the latter but at the same time we expect investors to favour the US as investment destination. As a result, these currencies will move lower. The most vulnerable currencies are of the countries with large current account deficits (Brazil, Colombia, Peru, South Africa, Ghana, and Central America), large fiscal deficits (Brazil, Central America, South Africa, and Ghana) and weak domestic growth (Russia, Brazil).

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Recovery of oil and base metal prices should support related currencies

We expect energy currencies such as the Canadian dollar, Russian ruble, Norwegian krone, Indonesia rupiah, Mexican peso and Colombian peso to receive support from a recovery in oil prices. However, political developments (ruble), fundamentals (rupiah) and easing monetary policy (krone) could limit or even overshadow this support. As indicated below, the Canadian dollar is expected to be the less vulnerable in our view (see below). We also expect a recovery in copper prices because of stronger fundamentals and strong global growth. This should provide some support to the Chilean peso. However, further monetary policy easing remains a risk.

Canadian dollar to be least vulnerable going forward

The Canadian dollar (CAD) has declined by more than 15% against the USD since crude oil declined in July last year. The magnitude of depreciation in the CAD this month is also unprecedented since the global financial crisis in 2008. The latter was due to an unexpected interest rate cut by the Bank of Canada (BoC) earlier this month. We judge that this was a move to insure the economy against the negative spill over effects from the sharper than expected decline in crude oil.

We expect the Canadian dollar to be the least vulnerable commodity currency for the following reasons. For starters, we do not expect further rate cuts by the Bank of Canada because core inflation is not projected to decline substantially and to remain close to 2% target this year. Moreover, the strong US economy should also support the Canadian economy. Last but not least, a recovery in oil prices should dampen the downside in the Canadian dollar.

Despite our less pessimistic outlook on the CAD, there is room for the CAD to weaken to 1.27 against the USD. This is mainly due to the divergence in monetary policy and economic growth outlook between the US and Canadian economy.

Neutral to modest rise in coffee and sugar prices should provide some support to the Brazilian real and other currencies of coffee/sugar exporting countries

Coffee prices are in the grips of Brazilian weather forecasts. Another dry period could cause a repeat of last year’s lower production, which will mean higher prices.

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We expect sugar prices to show a modest rise in the upcoming months, because the impact of low oil prices and the weak Brazilian real is mostly reflected in prices. The market remains in oversupply but we expect this supply to diminish.

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Developments in coffee and sugar prices will likely provide some support to currencies of coffee and sugar exporting countries such as the Brazilian real and currencies of Central America. However, this will probably only dampen the downside, because US dollar strength and weak domestic fundamentals will dominate in our view.

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