by Jim Vrondas

It is well known that our economy is heavily dependent on commodity exports. Around 60% of our total exports - Metals (28%), Coal (18%), Oil & Gas (9%) and Agriculture (5%) are for commodities. In April the total Australian dollar value of our exports ($28.5 billion) almost matched imports ($28.6 billion) with the shortfall, just over $100 million, coming because imports exceeded exports - this is the first trade deficit since October last year.

It is no surprise that the majority of our exports still go to China. In fact exports to China reached a new record high, up 5% on the previous month to be 25% higher than a year ago with iron ore increasing 29% over the same period. In this context the fact imports were able to outpace exports is remarkable and true testament to the strength of the Australian economy. So the deficit doesn’t worry me at present.

Such large sums of imports and exports also have implications for foreign exchange markets as currency is exchanged as a consequence. For a number of reasons that I won’t go into in this piece the currency exchange does not equal the dollar value of these international transactions. Suffice to say however that the value of the Aussie dollar is influenced by these movements, hence the correlation between commodity prices and the local currency has always been quite high – I’ll come back to this relationship shortly.

What is the RBA on about?

For over a year now the RBA has been saying our terms of trade have peaked and the Aussie dollar has remained at historically high levels. In its last statement the bank pointed towards some of those commodities “important to Australia” that “have continued to decline of late.”

The Trade Balance data that came out a few days after the last RBA meeting saw farm exports decline 6%, the largest monthly drop in over two years. In addition there is growing speculation that iron ore and coal prices might continue to fall as they have in recent times. To this extent the RBA might eventually find the Aussie dollar drift lower IF commodity prices do what people expect. But of course we all know markets often do the unexpected.

Commodity Index highly correlated to the Aussie dollar

With good reason investors often track the price of Iron Ore or other key commodities for currency direction. There are however several indices that can provide a broader view of performance in these sectors. For a long time the Commodity Research Bureau’s (CRB) Index of futures prices has been a favourite of mine as it is a fairly reliable measure of the performance of a basket of commodities. When overlaid against the Aussie dollar the correlation over a long period of time is pretty clear.
 

Source: http://www.globicus.com

The correlation is based on the principle that commodity price moves precede a move in the currency.

The move higher in the Aussie dollar at the beginning of the year seemed to follow the move higher in the CRB however in recent weeks the Aussie appreciation has come at a time when commodities have come off. This does support the view that the currency may be getting close to a peak but I get the sense economic developments in China and the broader trend for the CRB may provide only a brief dip in the Aussie dollar.

Jim Vrondas is Chief Currency strategist, Asia-Pacific at OzForex, a global provider of online international payment services and a key provider of Forex news. OzForex Group Limited, is a publicly listed entity with shares traded on the Australian Securities Exchange under the code "OFX".