Terms of Trade: Why Export Prices Shape a Currency

[Fairman]

Terms of Trade: Why Export Prices Shape a Currency

Terms of trade measure the ratio of a country's export prices to its import prices. When export prices rise relative to import prices, the country can buy more imports for the same amount of exports, and its terms of trade improve.

For commodity exporters like Australia, Canada, and New Zealand, the link is strong. If iron ore prices rise, Australia earns more from each tonne exported, which tends to support the Australian dollar. A fall in dairy prices weighs on New Zealand's income and often the kiwi.

The effect works through several channels. Higher export earnings raise demand for the currency from foreign buyers. Stronger income encourages investment and growth, which can lead to higher interest rates. And improved national income supports confidence.

The relationship is not perfect. Interest rate expectations, global risk appetite, and the US dollar often outweigh commodity price effects. A rise in iron ore does not always lift the Australian dollar if risk sentiment sours.

Still, watching the main export price offers a useful cross-check. If a commodity currency falls while its key commodity rises, other factors are driving it, and understanding which can sharpen your thesis.

Importers, like Japan, face the reverse. Higher oil prices worsen terms of trade and can weigh on the yen.

Practical step: identify the main export commodity for one commodity currency, and chart both together over a year.

[Fairman]

For AUD I keep iron ore and copper on a watchlist, for CAD it's oil, and for NZD dairy auction results. I don't trade them directly, but they're a quick sanity check when the currency moves and the news feed is quiet.

[Fairman]

One wrinkle: the commodity price that matters is often in a contract or index, not the spot price you see on a chart. The link to the currency is real but loose, so look at weeks, not hours.