Currency risks to commodities in 2016

The strength of the US has been one of the key factors undermining commodity prices in 2015 as the risks to US$ interest rates shifted along with FOMC policy. Countries with poor economic fundamentals were exposed in this environment, with the collapse of the Brazilian Real and Russian Rouble an example of this.

The change in direction in the Chinese Yuan was also an important event for FX and commodity markets, even if the move was relatively small. 

The yuan had been incredibly steady against the US dollar up until mid-2015 as it rallied against other currencies. In August, the PBOC adjusting the trading band and official fixing methodology given the pressure from capital outflows, a weak economy and the desire to satisfy the IMF as the Yuan heads towards SDR inclusion all led to the adjustment in the FX regime.

The consensus appears to be that the US dollar will continue to strengthen in 2016, although perhaps this will be more on a case-by-case basis rather than the broad-based gains seen in the last few years. 

For example, there has been little differentiation between the movement in the Australian dollar , the South African Rand or Canadian dollar in 2015 up until very recently. The combination of the sacking of South Africa's finance minister, the collapse of oil prices and the better than expected Australian economic data appears to have driven a wedge between these currencies lumped in the "commodity currency" basket.

It is also important to note that while US$ interest rates have moved higher at the shorter end of the curve, the longer-end is still below levels seen a few years ago.

While FX markets have tended to react very strongly to shifts in policy stance, they cannot totally ignore the expectations built into the longer end of the yield curve. The compression in spreads between 2 and 10 year yields is a surprising in the context of the market response to the end of Fed bond purchases back in 2013.

The path of the yuan is probably going to be more important to commodity markets in 2016 than the broad moves in the US dollar. For bulk commodities these directly affects netback prices to domestic markets, which have a huge influence on international prices. Eroding the international purchasing power of the world's largest consumer of metals is also likely to have a big impact on base and precious metals.

The Chinese Yuan has been appreciating very strongly on an effective exchange rate basis for quite a few years (we wrote about this back in 2014). With the domestic economy only getting weaker through 2015, there is a good case to suggest that macro economic fundamentals do not support the the Yuan at current levels against a basket of currencies.

How Chinese policy makers wish to manage this adds additional difficulty from a forecasting perspective. While a lower exchange rate improves the competitiveness of Chinese companies to international peers, signalling a lower exchange rate does create credit risks via capital outflow, which Chinese policy makers need to manage to maintain control over the banking system.

Foreign exchange reserves still remain so large that it seems likely that they can sterilize the impact of capital outflow on the Yuan and keep the depreciation and path of domestic credit relatively orderly. But understanding what level of the yuan will be deemed appropriate by both Chinese policy makers and international markets is pretty unclear at this stage.

The Yuan has fallen about 4.5pc since the middle of the year against the USD. The risk appears to be that the Yuan falls another 5-10pc vs. the USD over the next 12 months, although keep in mind that there maybe more divergence in currency performance against the USD in 2016. Ultimately the trigger for capital outflow to ease will be better signs in macroeconomic indicators and Chinese asset market performance. This appears someway off yet.

All other things being equal, commodities which function as pure netback to Chinese dometsic prices should probably fall by the same amount in the absence of any changes to market conditions. But this is rarely the case and it is likely that the changes in the Yuan will be much more steady than the potential moves in commodity prices, which can easily move 5pc+ in a day let alone an entire year.

So the focus should continue to be on whether there is any marginal changes in the demand and supply balance which could skew prices one way or another. A depreciating Yuan is a risk lurking in the background, but not one which should overwhelmingly determine commodity price performance.