There is extensive research literature on the dynamic relationship between commodity pricing and exchange rates, with different causal mechanisms linking the two with different implications. Two explanations in particular have gained more attention and prominence, with one heavily relying on macroeconomics and trade theory, and the other on features of the forex market. The first explanation suggests that a change in the commodity index price results in a change in the exchange rate of the corresponding currency of the commodity, which would help in predicting the exchange rate movements. The second explanation proposes a reverse idea, with exchange rates predicting the commodity prices.

Direction of Causality

Variation in Commodity Prices Leading to Changes in Exchange Rates

The first explanation is particularly relevant to small open economies (SOE). A small open economy is defined as an economy that takes part in international trade, but is significantly smaller as compared to its trading partners, and therefore any changes in its policies do not influence or change the global prices, incomes or interest rates. Thus, any small open economy whose exports rely significantly on a single commodity faces currency appreciation with an increase in the price of that commodity, as it results in an increase in demand for domestic currency, creating an upward pressure.

According to this theory, it is possible to predict the exchange-rate movements by using economic variables. However, forecasting exchange rates is particularly difficult, and there usually exists a difference between empirical cogency or statistical evidence, and the economic models of exchange rate determination.

Higher commodity prices in the short run often lead to an appreciation of the domestic currency, due to an increased supply of forex in the commodity exporters’ markets owing to the uptick in export revenues. This phenomenon may be compounded in the medium-to-long run as a result of foreign direct investment (FDI), due to more attractive investment possibilities and prospects in the domestic or local commodity sector.

In the commodity exporting countries, the changes in the export price usually outweigh the changes in the import price, and thus the variations in price of important export commodities is often regarded as a safe proxy for the movements in the terms-of-trade. Thus, there would exist a dynamic causal relationship between commodity prices and exchange rates.

Variation in Exchange Rates Leading to Changes in Commodity Prices

The second theory posits that like most other asset prices, exchange rates are determined by the NPV, or net present value of fundamentals, which includes the commodity prices. This theory uses the Granger causality — a mathematical formulation based on the linear regression modeling of stochastic processes, and that the exchange rates should Granger-cause commodity prices. This enables one to statistically analyse the movements in commodity prices, according to the movements in nominal exchange rates.

It has been postulated that the exchange rates of various small commodity exporters can be used to forecast global commodity prices. However, commodity prices can be extremely volatile, making them difficult to predict.

Factors Considered While Examining the Causal Relationships

Various research papers have been published, with extensive studies undertaken to obtain the relationship between exchange rates and commodity prices. The causal relationships were examined empirically, using country-specific commodity export price indexes (CXPIs) and high-frequency data (daily and intra-day), along with various other factors, such as different horizons, daily and 5-minute data of nominal exchange rates, commodity spot prices, S&P 500 index price and short-term interest rates for the duration, conditional and unconditional causality measures, and non-U.S. dollar exchange rates. Linear forecasting has been done by either using the vector autoregressive moving-average (VARMA) model, or the random-walk model.

Relationship Between Exchange Rates and Commodity Prices

By estimating the causality measures at different horizons in both directions, the strength of the linkages between exchange rates and commodity prices can be determined. Evidence of a strong, robust and dynamic relationship between commodity prices and exchange rates was found, with Granger-causality existing between commodity prices and exchange rates in both directions. That is, by using commodity prices, along with other factors such as interest rate, it is possible to determine exchange rates. Similarly, exchange rates can be effectively used to forecast future commodity prices. However, studies have also shown that the measured strength is much stronger while using commodity prices to predict exchange rates (direction of commodity prices to exchange rates), particularly at short horizons.