CAN EXCHANGE RATES FORECAST COMMODITY PRICES?*
(University of Washington)
October 26, 2009
Abstract. We show that "commodity currency" exchange rates have remarkably robust power
in predicting global commodity prices, both in-sample and out-of-sample, and against a variety
of alternative benchmarks. This result is of particular interest to policymakers, given the lack of
deep forward markets in many individual commodities, and broad aggregate commodity indices in
particular. We also explore the reverse relationship (commodity prices forecasting exchange rates)
but …nd it to be notably less robust. We o¤er a theoretical resolution, based on the fact that
exchange rates are strongly forward looking, whereas commodity price ‡uctuations are typically
more sensitive to short-term demand imbalances
J.E.L. Codes: C52, C53, F31, F47.
Key words: Exchange rates, forecasting, commodity prices, random walk.
*We would like to thank the editor, three anonymous referees, C. Burnside, F. Diebold, G. Elliott, C.
Engel, J. Frankel, M. McCracken, H. Rey, R. Startz, V. Stavrakeva, A. Tarozzi, A. Timmermann, M. Yogo
and seminar participants at the University of Washington, University of Pennsylvania, Boston College, Uni-
versity of British Columbia, UC Davis, Georgetown University, the IMF, the 2008 International Symposium
on Forecasting, and the NBER IFM Program Meeting for comments. We are also grateful to various sta¤
members of the Reserve Bank of Australia, the Bank of Canada, the Reserve Bank of New Zealand, and
the IMF for helpful discussions and for providing some of the data used in this paper. Data and replication
codes are available on authors’websites.
This paper demonstrates that the exchange rates of a number of small commodity exporters have
remarkably robust forecasting power over global commodity prices.
The relationship holds both
in-sample and out-of-sample.
It holds when non-dollar major currency cross exchange rates are
used, as well as when one controls for information in the forward or futures markets. We also …nd
that commodity prices Granger-cause exchange rates in-sample, assuming one employs suitable
methods to allow for structural breaks. However, this relationship is not robust out-of-sample.
The success of these exchange rates in forecasting global commodity prices is no deus ex machina.
It follows from the fact that the exchange rate is forward looking and embodies information about
future movements in the commodity markets that cannot easily be captured by simple time series
For the commodity exporters we study, global commodity price ‡uctuations a¤ect a
substantial share of their exports, and represent major terms-of-trade shocks to the value of their
currencies. When market participants foresee future commodity price shocks, this expectation will
be priced into the current exchange rate through its anticipated impact on future export income
and exchange rate values. In contrast, commodity prices tend to be quite sensitive to current global
market conditions, as both demand and supply are typically quite inelastic.1 Financial markets
for commodities also tend to be far less developed and much more regulated than for the exchange
rate. As a result, commodity prices tend to be a less accurate barometer of future conditions
than are exchange rates, hence the asymmetry between forecast success in the forward and reverse
1 Standard theories of the commodity markets focus on factors such as storage costs, inventory levels, and short-
term supply and demand conditions (see Williams and Wright 1991, Deaton and Laroque 1992). The prices of
agricultural products are well-known to have strong seasonality, and are commonly described by an adaptive "corn-
hog cycle" model. Structural breaks in the supply and demand conditions (e.g. China’s rapid growth, rising demand
for biofuels) have also been put forth as one of the major contributors to the recent commodity price boom (e.g.
World Bank 2009). It is intuitive that the prices of perishable commodities, or ones with large storage costs, cannot
incorporate expected future prices far into the future; though the prices of certain storable commodities such as silver
or gold may behave like forward-looking assets.
Although properly gauging commodity price movements is crucial for in‡ation control and
production planning alike, these prices are extremely volatile and have proven di¢ cult to predict.3
In a 2008 speech, Federal Reserve Chairman Ben Bernanke noted especially the inadequacy of
price forecasts based on signals obtained from the commodity futures markets, and emphasized the
importance of …nding alternative approaches to forecast commodity price movements.4 This paper
o¤ers such as an alternative.
Our laboratory here is that of the “commodity currencies” which
include the Australian, Canadian, and New Zealand dollars, as well the South African rand and the
Chilean peso. As these ‡oating exchange rates each embody market expectations regarding future
price dynamics of the respective country’s commodity exports, by combining them we are able to
forecast price movements in the overall aggregate commodity market.
Given the signi…cant risk
premia found in the commodity futures, our exchange rate-based forecasts may be an especially
We are not the …rst to test the present value models of exchange rate determination by examining
how it predicts fundamentals. For example, Engel and West (2005), following Campbell and Shiller
(1987), show that because the nominal exchange rate re‡ects expectations of future changes in its
2 The existing literature provides only scant empirical evidence that economic fundamentals can consistently explain
movements in major OECD ‡oating exchange rates, let alone actually forecast them, at least at horizons of one year
Meese and Rogo¤’s (1983a,b, 1988) …nding that economic models are useless in predicting exchange rate
changes remains an outstanding challenge for international macroeconomists, although some potential explanations
have been put forward. Engel and West (2005), for example, argue that it is not surprising that a random walk forecast
outperforms fundamental-based models, as in a rational expectation present-value model, if the fundamentals are I(1)
and the discount factor is near one, exchange rate should behave as a near-random walk. See also Rossi (2005a, 2006)
for alternative explanations. Engel, Mark and West (2007) and Rogo¤ and Stavrakeva (2008) o¤er discussions of the
3 Forecasting commodity prices is especially important for developing economies, not only for planning production
and export activity, but also from the poverty alleviation standpoint.
India, for example, distributes through its
Public Distribution System, thousands of tons of foodgrains each year at subsidized prices. Accurate forecast of
movements in foodgrains prices has signi…cant budgetary bene…t.
4 See www.federalreserve.gov/newsevents/ speech/bernanke20080609a.htm
5 See Gorton and Rouwenhorst (2006) and Gorton, Hayashi, and Rouwenhorst (2008) for a detailed description
and empirical behavior of the commodity futures risk premia.
economic fundamentals, it should help predict them.
However, previous tests employ standard
macroeconomic fundamentals such as interest rates, output and money supplies which are plagued
by issues of endogeneity, rendering causal interpretation impossible and undermining the whole
approach.6 This problem can be …nessed for the commodity currencies, at least for one important
exchange rate determinant: the world price for an index of their major commodity exports.
Even after so …nessing the endogeneity problem, disentangling the dynamic causality between
exchange rates and commodity prices is still complicated by the possibility of parameter instabil-
ity, which confounds traditional Granger-causality regressions.7 After controlling for instabilities
using the approach of Rossi (2005b), however, we uncover robust in-sample evidence that exchange
rates predict world commodity price movements. Individual commodity currencies Granger-cause
their corresponding country-speci…c commodity price indices, and can also be combined to predict
movements in the aggregate world market price index.
As one may be concerned that the strong ties global commodity markets have with the U.S.
dollar may induce endogeneity in our data, we conduct robustness checks using nominal e¤ective
exchange rates as well as rates relative to the British pound.8 Free from potential "dollar e¤ect",
the results con…rm our predictability conclusions. We next consider longer-horizon predictability
as an additional robustness check, and test whether exchange rates provide additional predictive
6 This problem is well-stated in the conclusion of Engel and West (2005), ”Exchange rates might Granger-cause
money supplies because monetary policy makers react to the exchange rate in setting the money supply. In other
words, the preset-value models are not the only models that imply Granger causality from exchange rates to other
7 Disentangling the dynamic relationship between the exchange rate and its fundamentals is complicated by the
possibility that this relationship may not be stable over time. Mark (2001) states, “. . . ultimately, the reason boils
down to the failure to …nd a time-invariant relationship between the exchange rate and the fundamentals.” See also
8 For example, since commodities are mostly priced in dollars, one could argue that global commodity demands
and thus their prices would go down when the dollar is strong. Another reason to consider non-dollar exchange rates
is that the US accounts for roughly 25% of total global demand in some major commodity groupings, and therefore
its size might be an issue.
power beyond information embodied in commodity forward prices and futures indices.9
In the …nal section, we summarize our main results and put them in the context of the earlier
literature that focused on testing structural models of exchange rates.
Background and Data Description
Although the commodity currency phenomenon may extend to a broader set of countries, our study
focuses on …ve small commodity-exporting economies with a su¢ ciently long history of market-
based ‡oating exchange rates, and explores the dynamic relationship between exchange rates and
world commodity prices.
We note that the majority of the commodity-exporting countries in
the world either have managed exchange rates or haven’t free-‡oated their currencies continuously.
While their exchange rates may still respond to commodity prices, we exclude them in our analysis
here as our interest is in how the market, rather than policy interventions, incorporates commodity
price expectations in pricing currencies.
As shown in Appendix Table A.1, Australia, Canada, Chile, New Zealand, and South Africa
produce a variety of primary commodity products, from agricultural and mineral to energy-related
goods. Together, commodities represent between a quarter and well over a half of each of these
countries’total export earnings. Even though for certain key products, these countries may have
some degree of market power (e.g. New Zealand supplies close to half of the total world exports of
lamb and mutton), on the whole, due to their relatively small sizes in the overall global commodity
market, these countries are price takers for the vast majority of their commodity exports.10 Substi-
9 Forward markets in commodities are very limited –most commodities trade in futures markets for only a limited
set of dates.
1 0 In 1999, for example, Australia represents less than 5 percent of the total world commodity exports, Canada
about 9 percent, and New Zealand 1 percent. One may be concerned that Chile and South Africa may have more
market power in their respective exports, yet as shown and discussed further in Appendix C, we cannot empirically
reject the exogeneity assumption.
tution across various commodities would also mitigate the market power these countries have, even
within the speci…c market they appear to dominate. As such, global commodity price ‡uctuations
serve as an easily-observable and essentially exogenous terms-of-trade shock to these countries’
From a theoretical standpoint, exchange rate responses to terms-of-trade shocks can operate
through several well-studied channels, such as the income e¤ect of Dornbusch (1980) and the
Balassa-Samuelson e¤ect commonly emphasized in the literature (Balassa 1964 and Samuelson
In the next two subsections, we discuss possible structural mechanisms that explain the
link between exchange rates and commodity prices as well as economic interpretations of our em-
pirical results. We note that in the empirical exchange rate literature, sound theories rarely receive
robust empirical support, not to mention that for most OECD countries, it is extremely di¢ cult
to actually identify an exogenous measure of terms-of-trade. The commodity currencies overcome
these concerns. Not only are exogenous world commodity prices easy to observe from the few cen-
tralized global exchanges in real time, they are also a robust and reliable fundamental in explaining
the behavior of these commodity currencies, as demonstrated in previous literature.11
Over the past few decades, all of these countries experienced major changes in policy regimes
and market conditions. These include their adoption of in‡ation targeting in the 1990s, the estab-
lishment of Intercontinental Exchange and the passing of the Commodity Futures Modernization
Act of 2000 in the United States, and the subsequent entrance of pension funds and other investors
into commodity futures index trading.
We therefore pay special attention to the possibility of
structural breaks in our analyses.
1 1 Amano and van Norden (1993), Chen and Rogo¤ (2003, 2006), and Cashin, Cespedes, and Sahay (2004), for
example, establish commodity prices as an exchange rate fundamental for these commodity currencies
By commodity currencies we refer to the few ‡oating currencies
that co-move with the world prices of primary commodity products, due to these countries’heavy
dependency on commodity exports. The theoretical underpinning of our analysis - why commodity
currencies should predict commodity prices - can be conveniently explained in two stages. First,
world commodity prices, being a proxy for the terms of trade for these countries, are a fundamental
determinant for the value of their nominal exchange rates. Next, as we show in Section 2.2 below,
because the nominal exchange rate can be viewed an asset price, it incorporates expectations about
the values of its future fundamentals, such as commodity prices.
There are several channels that can explain why, for a major commodity producer, the real (and
nominal) exchange rate should respond to changes in the expected future path of the price of its
commodity exports. Perhaps the simplest mechanism follows the traded/nontraded goods model
of Rogo¤ (1992), which builds upon the classical dependent-economy models of Salter (1959) and
Swan (1960) and Dornbusch (1980).
Rogo¤’s model assumes …xed factors of production, and a
bonds-only market for intertemporal trade across countries (i.e., incomplete markets).
exchange rate –the relative price of traded and nontraded goods –depends at any point in time on
the ratio of traded goods consumption to nontraded goods consumption; see Rogo¤ (1992, eq.6).
But traded goods consumption depends on present value of the country’s expected future income
(and on nontraded goods shocks except in the special case where utility is separable between
traded and nontraded goods.)
Thus the real exchange rate incorporates expectations of future
commodity price earnings. If factors are completely mobile across sectors as in the classic Balassa
and Samuelson (1964) framework employed by Chen and Rogo¤ (2003), the real exchange rate will
only depend on the current price of commodities. But as long as there are costs of adjustment in
moving factors (as in Obstfeld and Rogo¤, 1996, Ch. 4), the real exchange rate will still contain a
forward-looking component that incorporates future commodity prices. In general, therefore, the
nominal exchange rate will also incorporate expectations of future commodity price increases.12
Introducing sticky prices is another way to motivate a forward-looking exchange rate relation-
ship, either via the classic Dornbusch (1976) or Mussa (1976) mechanism or a more modern "New
Open Economy Macroeconomics" model as in Obstfeld and Rogo¤ (1996).13
In a Dornbusch
framework, combining money market equilibrium, uncovered interest parity, and purchasing power
parity condition leads to the familiar relationship:
yt ) + qt] + 1 +
where qt is the real exchange rate, mt and mt are domestic and foreign money supplies, yt and yt
are domestic and foreign output, and
is the interest elasticity of money demand.14
model is solved out for the exchange rate in terms of current and expected future fundamentals,
the result again is that nominal exchange rate depends on expected future commodity prices, here
embodied in qt.15
In addition to the channels discussed in the standard macro models above, the exchange rate-
commodity price linkage can also operate through the asset markets and a portfolio channel. For
example, higher commodity prices attract funds into commodity-producing companies or countries.
1 2 We note that in principle, real exchange rate shocks need not translate to the nominal exchange rate, such as
when the country is under a …xed exchange rate regime. If the monetary authorities stabilize the exchange rate,
the real exchange rate response will pass through to domestic prices, inducing employment e¤ects in the short run
if prices are not fully ‡exible. This is why in our choice of commodity currencies, we only focus on countries with
‡oating exchange rates.
1 3 The exogenous commodity price shocks enter these models in a similar fashion as a productivity shock to the
export sector, and the forward-looking element of nominal exchange rate is the result of intertemporal optimization.
See, for example, Obstfeld and Rogo¤ (1996, Ch.10.2) and Garcia-Cebro and Varela-Santamaria (2007).
1 4 See, for example, Engel and West (2005) equation 7 for a derivation of this standard result.
1 5 We emphasize, however, that the net present value relation between nominal exchange rate and commodity prices
do not need sticky prices, and the e¤ect does not have to come from asset markets either, although it can.
This may imply additional empirical relationship between equity market behavior and world com-
modity prices. The objective of this paper is not to distinguish amongst these alternative models,
but rather to explore and test the consequences of this fundamental linkage between nominal ex-
change rates and commodity prices. We will choose as our main starting point, therefore, a very
general expression for the spot exchange rate:
st = 0ft + Etst+1
where the commodity price, cpt is one of the fundamentals ft. Again, this forward looking equation
can be motivated from asset markets as in Engel and West (2005), but can also be motivated through
goods markets assuming factor mobility is not instantaneous.
Finally, we note that, in principle, the theoretical channels we discuss above may as well apply
to countries that heavily import commodity products, not just countries that heavily export. That
is, commodity price ‡uctuations may induce exchange rates movements (in the opposite direction)
for large commodity importers.
However, we suspect that empirically, this relationship may be
muddled by the use of these imported raw materials as intermediate inputs for products that are
subsequently exported. To preserve a clean testing procedure, we do not include large importers
in our analyses.16
The Present Value Approach.
In this section, we discuss the asset-pricing approach
which encompasses a variety of structural models, as discussed above, that relate the nominal
exchange rate st to its fundamentals ft and its expected future value Etst+1. This approach gives
1 6 We believe further investigation on the applicability of the "commodity currency" phenomenon to large importers
is an interesting topic, but we leave it for future research.
rise to a present value relation between the nominal exchange rate and the discounted sum of its
expected future fundamentals:
st = P jEt(ft+jjIt)
are parameters dictated by the speci…c structural model, and Et is the expectation
operator given information It. It is this present value equation that shows that exchange rate s
should Granger-cause its fundamentals f . (Note that using the model of Rogo¤ (1992), or Obstfeld
and Rogo¤ (1996, Ch. 4), one can motivate a similar relationship with the real exchange rate q
on the left hand side of eq.(1) We prefer here to focus on the nominal exchange rate, as it is, in
principle, measured more accurately and at very high frequency, as are commodity prices.
one could in principle extend the exercise here to the real exchange rate.).
While the present value representation is well accepted from a theoretical standpoint, there is
so far little convincing empirical support for it in the exchange rate literature.17
The di¢ culty
lies in the actual testing, as the standard exchange rate fundamentals considered in the literature -
cross country di¤erences in money supply, interest rates, output, or in‡ation rates - are essentially
all endogenous and jointly determined with exchange rates in equilibrium. They may also directly
react to exchange rate movements through policy responses.
Under such conditions, a positive
…nding that exchange rate s Granger-causes fundamental f could simply be the result of endogenous
response or reverse causality, and is thus observationally equivalent to a present value model. For
instance, a positive …nding that exchange rates Granger-cause money supply or interest rate changes
may be the direct result of monetary policy responses to exchange rate ‡uctuations, as would be the
1 7 The present value approach to modeling nominal exchange rate is discussed in standard textbooks such as Mark
(2001) and Obstfeld and Rogo¤ (1996), as well as emphasized in recent paper such as Engel and West (2005). It
follows the same logic as the dividend yields or the consumption-wealth ratio embodying information about future
dividend growths or stock returns (see Campbell and Shiller 1988, Campbell and Mankiw 1989, and the large body
of follow-up literature.)