When The Walk Is Not Random: Commodity Prices And Exchange Rates

Emanuel Kohlscheen

Bank for International Settlements (BIS)

Fernando H. Avalos

Bank for International Settlements (BIS)

Andreas Schrimpf

Bank for International Settlements (BIS) – Monetary and Economic Department

March 2016

BIS Working Paper No. 551

Abstract:

We show that there is a distinct commodity-related driver of exchange rate movements, even at fairly high frequencies. Commodity prices predict exchange rate movements of 11 commodity-exporting countries in an in-sample panel setting for horizons up to two months. We also find evidence of systematic (pseudo) out-of-sample predictability, overturning the results of Meese and Rogoff (1983): information embedded in our country-specific commodity price indices clearly helps improving upon the predictive accuracy of the random walk in the majority of countries. We further show that the link between commodity prices and exchange rates is not driven by changes in global risk appetite or carry.

When The Walk Is Not Random: Commodity Prices And Exchange Rates – Introduction

Recent developments in the oil market have brought the connection between commodity prices and the exchange rates of a number of countries back to the forefront of the policy debate. By affecting prospective inflows, substantial changes to the terms of trade of a given country are thought to exert a significant influence on exchange rates.

In the short-run, higher commodity prices lead to an increased supply of foreign exchange in the markets of commodity exporters, as a result of increased export revenues – causing an appreciation of the domestic currency. In the medium to long-run, this effect might then be compounded by ensuing foreign direct investment, as a result of more attractive investment prospects in the local commodity sector.

Commodity Prices And Exchange Rates

The above mechanisms tend to be fairly evident in the economies of commodity exporters. For such countries, price variation of key export commodities is often seen as a reasonably good proxy for terms of trade movements, as export price variation typically trumps the variation in import prices – which tends to be more dependent on more rigidly priced manufactured goods. Hence, changes in the prices of key exports may well bear a close link with exchange rate movements.

In this paper we analyze the relation between commodity prices and the exchange rates of key commodity exporters in a systematic way. We base our analysis on a more timely proxy for terms of trade, which is based on granular 3-digit UN Comtrade data as well as market price information of 83 associated proxy commodities – which were used to construct country-specific commodity export price indices (CXPIs) at daily frequency for 11 commodity-exporting countries.

The daily CXPIs allow us to analyze the relation between commodity prices and exchange rates with greater precision at different frequencies, as well as to tease out the extent to which this relation is independent of variations in global risk appetite or carry. We show how the information that is contained in these indices clearly improves the predictive performance of exchange rate models for all 11 of the commodity exporters that we study. In addition, the indices provide more prompt information about the direction in which equilibrium exchange rates may be moving. They could thus prove to be useful for the evaluation of central bank or sovereign wealth fund actions in FX markets.

Commodity Prices And Exchange Rates

We find that commodity prices predict exchange rate movements of commodity exporters up to two months ahead when the analysis is based on in-sample panel regressions. Out-of-sample estimations also show that simple linear predictive models based on our commodity price indices tend to have superior predictive performance for exchange rates when compared to random walk benchmarks. These findings hold true for the three advanced economies and eight emerging markets in our sample. They hold for bilateral variations against the US dollar and the Japanese yen, as well as for the nominal effective exchange rate variations.

The key finding that commodity price models dominate random walk models is based on the usual approach of utilizing realized variables as predictors (so-called pseudo out-of-sample tests), as pioneered by Meese and Rogoff (1983). As we show, evidence of out-of-sample predictability using only lagged predictors is clearly weaker, possibly as a consequence of the fact that commodity prices themselves are hard to predict.

We further show that variation in commodity prices has an effect on nominal exchange rates at high frequency that goes beyond the impact of global risk appetite. Daily variations in the Chicago Board Options Exchange volatility index (VIX) – also explain a share of the nominal exchange rate variation. But, commodity prices explain a significant part of the variation of the exchange rate that is orthogonal to risk. In other words, the high-frequency relation that exists between commodity prices and exchange rates goes beyond what is driven by the simultaneous movement of investors into (out of) commodity markets and high-yielding currencies during risk-on (risk-off) episodes. Our results are also found to be robust to the incorporation of information on short-term government bond yields differentials.

Commodity Prices And Exchange Rates

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