by Editor ISSUE 42 SEP/OCT 2010

Platinum Pursuits chief executive Daniel Kertcher explores the relationship between commodities and the value of the Australian dollar

Combined global commodity prices 2002 — 2009

In very simple terms, China is the world’s biggest manufacturing producer, America is the world’s biggest consumer and Australia is the world’s biggest mine. Australia is also a farm, but mostly a mine.

Commodities (resources, mining and farm products) are by far Australia’s largest export. In fact, Australia is the world’s largest exporter of coal, wool, zinc, tin, iron ore, beef, barley and raw sugar according to the 2006 UN Comtrade Database. We are also major exporters of gold, silver, uranium, natural gas and many other commodities.

Now, it must be said that there are many important contributing factors determining the value of international currencies such as interest rates, inflation, relative growth rates and much more. However, Australia’s currency is in practice very closely connected to global commodity prices due to our function in the global economy as one of the biggest sources of mining products as well as a large producer of farm products.

Here is the basic mechanism: as demand for commodities increase, the demand for the Australian dollars (AUD) needed to buy them from us also increases, thereby driving up the Australian dollar’s value compared to other currencies such as the US dollar (USD).

In 2001, commodity prices around the world were at record lows. Gold was trading at USD $250 an ounce (the lowest price in more than twenty years) crude oil was trading at USD $15 a barrel and wheat was trading at just USD $2.30 a bushel.

At the same time, the Australian dollar was also trading at a multi-decade low with an exchange rate of only USD$0.47. That means one Australian dollar was worth only 47 US cents.

However, starting in early 2002 and running for almost seven years until a peak in mid-2008, the commodity market started an unprecedented “bull run” fueled by a combination of massive demand from industrialization in emerging markets such as China, India and others, as well as an insatiable appetite for trading profits by international hedge funds.

These combined forces caused the commodity market to explode, resulting in high, triple digit percentage gains in virtually every commodity price. Gold hit a high of more than $1,000 USD an ounce, crude oil peaked at more than $148 USD a barrel and wheat topped out at more than $13 USD a bushel. During that same time, the value of the Australian dollar also enjoyed a record increase in value, peaking at USD$0.98 by mid-2008

The commodity market “bull run” came to a spectacular end towards the end of 2008, with five years of gains being lost in less than four months and prices returning to 2004 levels.

The value of the Australian dollar against the US dollar suffered a similar fate, falling by more than 38% in three months and bottoming out at around USD$0.60.

In the wake of the Global Financial Crisis, most major international governments have responded by injecting phenomenal amounts of cash into their respective economies – known as “stimulus packages” – and most central banks have done their part as well by lowering official interest rates. The combined effect, this massive increase in financial liquidity, appears to have reduced the degree of investor and consumer panic, but at what cost?

Global faith in paper currency has plummeted, as evidenced by a massive sell off in currency-based investments such as US Treasury Bonds in the first half of 2009.

Intelligent investors, highly concerned by a potential “crisis of confidence” associated with many paper currencies, have recognized the security of investing in more tangible assets such as commodities. As a result, investors have now turned their attention back to commodities, with the commodity market rising in value by more than 50% in the first half of 2009. In basic terms, commodities are becoming the new global currencies.

With the Australian dollar strongly linked to the value of commodities, the higher demand for commodities has helped push the Australian dollar back up to around USD$0.80.

The big question is, “What’s going to happen to commodity prices now?”

Regardless of the economic impact of the Global Financial Crisis (which will likely continue to act in the short-term to medium-term to depress commodities demand), emerging markets are still industrializing. The global population continues to grow. These are forces that will be in place for decades to come. These forces are positive for the medium-term to long-term demand for commodities and growing demand always exerts upward pressure on prices.

How far could commodity prices rise? Currently, global commodity prices could grow by more than 200% and still not equal the highs of 2008. And if commodity prices continue to rise in the future, the value of the Australian dollar will likely mirror this growth.

So, how can we trade the Australian dollar?

Trading currencies is relatively easy to learn, but can take years to master. Experienced currency traders use leverage ratios of between 1:50 and up to 1:400. That means that for every 1% movement in the currency value, the trader can make or lose between 50% and 400% of their money! That’s massive when you consider the Australian dollar fell by 38% in 3 months last year and has risen by more than 30% so far this year. Fortunes have definitely been made and lost by trading currencies.

Fortunately, for novice investors, who just want a small exposure to the currency market, there are Exchange Traded Funds (ETFs) which specifically trade currencies. Basically, you can buy shares in the currency ETFs and the share price mirrors the performance of the currency value. Because you are buying shares, the leverage ratio is a very modest 1:1, just like buying shares in a company.

Currency ETFs are traded on the US stock market, so you will need a broker who can trade American shares (of which there are many in Australia).

The code for the AUD/USD currency ETF is FXA. As the Australian dollar strengthens, FXA should rise.

By trading shares in FXA, investors can participate in the rise and fall of the Australian dollar, without the higher risks of leverage. Leverage can be increased to a factor of around 1:10 (still much lower leverage than most currency traders use), by trading CFDs on the currency ETFs.

It’s even possible to trade call and put options on the currency ETFs, thereby providing higher leverage with downside risk limits.