There has been an interesting discussion on how investing in commodities and currencies should be similar. This is an important insight because too often commodities have been discussed in the context of a long-only asset class which is a flawed approach, and currencies have been questioned as even an asset class. In fact, they should be considered asset classes that have special properties because they are consumed and used as a store of value.
The argument is that commodities and currencies are similar asset classes in that they will move up and down based on the excess stock available relative to what is "consumed". When there is excess supply versus demand inventory will build which will lead to a lower price in order to clear the excess. We have to look beyond the fact that money is supplied by fiat and look at the determination of price based on imbalances between supply and demand through time.
If we take this broad approach for both commodities and currencies, we can focus on the three drivers or factors that will affect each of these asset classes: carry, momentum, and fundamentals. There has been significant research work in the FX market to suggest that these three factors drive most of the variation in returns. The same can be said for commodities. In fact, investors can buy swaps which focus on a portfolio of each of these factors. This three factor approach can be applied consistently across each of these asset classes. We could easily add a fourth factor, volatility, that has often been used to describe returns, but to keep things simple we will focus on what could be called the big three.
Clearly, carry is an important part of any FX decisions because of the deep relationship between prices and interest rate differentials. Most of the FX research shows that the change in price of currencies over time can be effectively explained through buying the high rate currency and selling the low rate which will give the investors the rate differential as a carry. Similarly the carry component in commodities is determined by whether the market is in backwardation or contango. The investor should buy the futures for those markets markets in backwardation and pick-up the gains as price to cash levels. For markets in contango, the investor should be a seller, no different than a FX trader who is losing on his forward points. Both markets are driven by the strong effects of the forward curve which can serve as a headwind or a tailwind.
Momentum is a key driver in the FX markets. The trend will take place because there will be long-term imbalances in supply and demand that will cause prices to move in one direction for extended periods. If one country is following a expansionary monetary policy versus other who are engaged in tighter policies, there will be a consistent depreciation trend. In the commodities markets, there can be a supply or demand shocks that cannot be easily adjusted so there will be extended imbalances which will be associated with trends. The fact that each market is faced with significant uncertainty suggests that adjustments will be slow over time.
Fundamentals and fair value will also affect the foreign exchange markets through anything from the terms of trade to growth shocks. Expectations of future changes in fundamentals will have an impact on currency prices. In commodities, supply and demand shocks will cause prices to be out of balance and lead to price changes. The current decline in demand and its impact on price is a perfect example in the commodity markets. The expected change in Fed policy has had a strong impact on dollar gains relative to the euro and yen. This could all be viewed as coming from a supply and demand imbalance.
We can also add that changes in policy will have an impact on both markets and the flow of trade across countries will also be a clear driver for both commodities and currencies. One framework across two asset classes is a simple but effective means of looking at these markets.
The argument is that commodities and currencies are similar asset classes in that they will move up and down based on the excess stock available relative to what is "consumed". When there is excess supply versus demand inventory will build which will lead to a lower price in order to clear the excess. We have to look beyond the fact that money is supplied by fiat and look at the determination of price based on imbalances between supply and demand through time.
If we take this broad approach for both commodities and currencies, we can focus on the three drivers or factors that will affect each of these asset classes: carry, momentum, and fundamentals. There has been significant research work in the FX market to suggest that these three factors drive most of the variation in returns. The same can be said for commodities. In fact, investors can buy swaps which focus on a portfolio of each of these factors. This three factor approach can be applied consistently across each of these asset classes. We could easily add a fourth factor, volatility, that has often been used to describe returns, but to keep things simple we will focus on what could be called the big three.
Clearly, carry is an important part of any FX decisions because of the deep relationship between prices and interest rate differentials. Most of the FX research shows that the change in price of currencies over time can be effectively explained through buying the high rate currency and selling the low rate which will give the investors the rate differential as a carry. Similarly the carry component in commodities is determined by whether the market is in backwardation or contango. The investor should buy the futures for those markets markets in backwardation and pick-up the gains as price to cash levels. For markets in contango, the investor should be a seller, no different than a FX trader who is losing on his forward points. Both markets are driven by the strong effects of the forward curve which can serve as a headwind or a tailwind.
Momentum is a key driver in the FX markets. The trend will take place because there will be long-term imbalances in supply and demand that will cause prices to move in one direction for extended periods. If one country is following a expansionary monetary policy versus other who are engaged in tighter policies, there will be a consistent depreciation trend. In the commodities markets, there can be a supply or demand shocks that cannot be easily adjusted so there will be extended imbalances which will be associated with trends. The fact that each market is faced with significant uncertainty suggests that adjustments will be slow over time.
Fundamentals and fair value will also affect the foreign exchange markets through anything from the terms of trade to growth shocks. Expectations of future changes in fundamentals will have an impact on currency prices. In commodities, supply and demand shocks will cause prices to be out of balance and lead to price changes. The current decline in demand and its impact on price is a perfect example in the commodity markets. The expected change in Fed policy has had a strong impact on dollar gains relative to the euro and yen. This could all be viewed as coming from a supply and demand imbalance.
We can also add that changes in policy will have an impact on both markets and the flow of trade across countries will also be a clear driver for both commodities and currencies. One framework across two asset classes is a simple but effective means of looking at these markets.
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