Want to hedge your risks? Try ‘commodity currencies’

Commodities can play a unique role in investment portfolios.

Besides being assets that one can ‘see and feel’, they are potential sources of investment returns that are relatively less correlated with equities and bonds. In that sense, they offer exposure to ‘real’ assets that have historically performed well during periods of inflation or during times of elevated uncertainty.

For most investors, though, finding routes to add commodities to liquid investment portfolios is easier said than done. Outside of very few exceptions, it is generally very difficult to add exposure to most commodity price trends without owning the actual commodity itself. And practical considerations rule this out if you ask: Does your house or office have room to store a barrel of crude oil, a tonne of copper, or a bushel of wheat?

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Exchange Traded Funds and derivatives can offer some alternatives but they can often be too complex and imperfect for non-specialist investors.

Commodity currencies

Fortunately, currency markets can help investors get commodity-like exposure. While not perfect, several ‘commodity currencies’ offer relatively high correlation to specific commodities and can, thus, offer a way for most investors to build some commodity exposure in their portfolios through liquid financial markets.

The Australian Dollar (the ‘Aussie’), the New Zealand Dollar (the ‘Kiwi’) and the Canadian Dollar (the ‘Loonie’) are often the first port of call for investors looking to add commodity exposure to portfolios. Of course, commodities are not the only driver of these currencies – relative interest differentials, for example, still play a part – but even a simple chart illustrates that for many periods, these currencies have maintained a high correlation with prices of their respective market’s biggest commodity export.

Aussie as a gold and industrial metals play

Australia has always been a key commodities exporter and is well known for hosting some of the world’s largest commodity mining firms. The country’s balance of payments shows commodities, such as iron ore and gold, are amongst its biggest exports.

In recent decades, it also became a major exporter of key industrial metals, such as copper and LNG. Much of these commodities were exported to China as a construction boom there created considerable demand for many of Australia’s commodities.

This linkage meant the Australian Dollar’s correlation with the prices of its key commodity exports started to rise. While this offers relatively imperfect exposure to the commodity’s price, it does offer investors a way to add some exposure (which is better than no exposure) to these commodities.

New Zealand as a dairy powerhouse

New Zealand ranks amongst the world’s largest milk and dairy product exporters. This has meant that the New Zealand Dollar (or the ‘Kiwi’, a name derived from its national flightless bird), besides often benefitting from high interest rates, offers some exposure to commodities that are otherwise difficult to gain exposure through liquid investment portfolios.

Canada as an energy exporter

Crude oil, refined petroleum products and gold count among Canada’s largest exports. The country also holds one of the world’s largest reserves of crude oil in the form of oil sands. The Canadian Dollar (or the ‘Loonie’, a nickname for the currency derived from the loon bird featured on one side of the C$1 coin) has at various points in its history, offered an alternative route to adding exposure to crude oil prices, especially when they were at high levels.

Some exposure better than none

The three ‘Dollar Bloc’ currencies mentioned above – the AUD, NZD and CAD – might be the most popular and liquid commodity currencies but they are not the only ones with commodity-linkages. Chile’s Peso (the CLP), for instance, offers a relatively higher correlation with copper prices given copper ore and refined copper are one of the country’s largest exports.

It is worth highlighting that adding exposure to commodities via currencies is not perfect. Commodity prices are usually one of several drivers of these currencies and, at times, they compete with relative interest rates, which is usually one of the most important drivers of any currency pair.

However, even limited exposure to the asset class is uniquely valuable when it is difficult for the average investor to find a way to implement a view on spot commodity prices through a liquid and broadly accessible asset class.