Do Exchange Rates Really Help Forecasting Commodity Prices?

Abstract

Chen et al. (2010) report that for 'commodity currencies', the exchange rate predicts the country’s commodity index but not vice versa. The commodity currency hypothesis is consistent with the Engel and West (2005) exchange rate model if the fundamental is chosen to be the country’s key export prices and if the latter are exogenous to the exchange rate dynamics. In our view, however, commodity prices are essentially financial asset prices that are set in a forward-looking way, exactly like exchange rates. If both the exchange rate and the commodity prices are based on discounted future expectations, one should mostly observe contemporaneous correlations, not one-directional cross-predictability from one variable toward the other.Using three different data sets and various econometric techniques, we do find the contemporaneous correlations as predicted by the financial asset view of commodity prices. Cross-predictability, in contrast, seems to be only minor at best, not robust to plausible variations in the test design, and bi-directional rather than one-directional. The difference between Chen et al’s empirical findings and ours is to a large extent traceable to the presence of time-averaged prices in the commodity index data that they use. Price averaging induces spurious autocorrelation and predictability that disappears if one uses e.g. month’s-end prices. Some slip-ups in their test design seem to play an additional role too.