| Abstract: |
Understanding and measuring the relative roles of different causal channels
between commodity prices and exchange rates has important implications in
financial decision making, especially for market participants with short
horizons. From a macroeconomic perspective, this can also be useful for
interpreting exchange rate movements, financial market monitoring and monetary
policy. Basic economic reasoning on currency demand suggests that the
currencies of countries whose exports depend heavily on a particular commodity
should be strongly influenced by its price, so commodity price movements
should lead (Granger-cause) exchange rate movements (macroeconomic/trade
mechanism). In contrast, the present value model of forward-looking exchange
rates suggests reverse causation, i.e. exchange rates should Granger-cause
commodity prices (expectations mechanism). We examine empirically the causal
relationship between commodity prices and exchange rates, using data on three
commodities (crude oil, gold, copper) and three countries (Canada, Australia,
Chile), over the period 2000-2009. To go beyond pure significance tests of
non-causality and to provide a relatively complete picture of the links,
measures of the strength of causality for different horizons and directions
are estimated and compared. Since low-frequency data may easily fail to
capture important features of the relevant causal links in volatile financial
markets – such as foreign exchange and commodity markets – high-frequency
(daily and 5-minute) data are exploited. Both unconditional and conditional
(given general stock market conditions) causality measures are considered, and
allowance for “dollar effects” is made by considering non-U.S. dollar
variables. We identify clear causal patterns: (1) Granger causality between
commodity prices and exchange rates is visible in both directions; (2) it is
stronger at short horizons, and becomes weaker as the horizon increases; (3)
causality from commodity prices to exchange rates is stronger than causality
in the reverse direction across multiple horizons: the ratios of causality
measures in two different directions can be quite high (for example, as high
as 5 or 10 in favor of causation from commodity prices to exchange rates),
especially at short horizons; (4) eliminating dollar effects weakens causality
from exchange rates to commodity prices, and reveals a more definite pattern
where causality from commodity prices to exchange rates dominates across
multiple horizons. In contrast with earlier results on the non-predictability
of exchange rates, we find that the macroeconomic/trade-based mechanism plays
a central role in exchange rate dynamics, despite the financial features of
these markets. |
| Keywords: |
multi-horizon causality, causality measures, commodity prices, exchange rates, stock prices, high-frequency data, spurious causality, financial markets, |