The different composition of these three commodity indices affects their relative price performance. The energy-laden Goldman Sachs index pulled ahead of its rivals in late 2004. But regardless of which index (if any) you prefer, it is easy to see how both the CAD and the AUD rallied well ahead of the physical commodity indices with the March 2003 start of the Iraq War.

This war has had two major impacts on the linked worlds of financial and physical markets: It injected a risk premium into energy markets and it encouraged the Federal Reserve to keep credit easier than it would have been otherwise to finance it. The Federal Open Market Committee went so far as to talk about preventing deflation in its May 2003 statement of bias; this occurred within one week after President Bush landed on the deck of the Abraham Lincoln underneath a “Mission Accomplished” banner.

The rules of causation are straightforward. We can go with the formal statistical definition, for which Clive Granger received a Nobel Memorial Prize in Economics in 2003: X causes Y if lagged values of X improve the forecasting capabilities provided by lagged values of Y.

Or we can keep it simple and say for X to cause Y, it first and foremost must precede Y in time. If the CAD and AUD strengthened ahead of the big bull run in the commodity indices, it is impossible for commodity prices alone to account for the strength of these currencies. Moreover, lumping the two dollars together as if they were somehow linked by a set of common factors ignores large segments of their relative performance history. The two traded in parallel between 1994 and 2004, but often diverged prior to that point and certainly have diverged during the large commodity rally since 2004. Something besides commodity prices must be involved.

The answer, unsurprisingly, is interest rate differentials. If we take the difference between six month LIBOR yields for these two currencies against the U.S. dollar (USD) and divide it by the USD six month LIBOR rate, we find the interest-rate differential between those two currencies and the USD expanded rapidly between 2001 and 2003, the period in which the two currencies’ rallies began. Six month CAD LIBOR has been trading under six-month USD LIBOR since December 2004, and the AUD’s gap has nearly disappeared as well. It is fair to say the CAD and AUD rallies were first a function of interest rate differentials and then and only then were a function of commodity prices.

Both Canada and Australia are large and diverse economies with liquid and functioning capital markets. Arbitrage between interest rate and currency markets is efficient and inexpensive in both cases. Let’s take a look now at some smaller, less diverse economies with greater single-commodity linkages to their export revenues.