Oil prices are not a good proxy to predict exchange rate movements, and vice versa, a recent study by Joscha Beckmann, Robert Czudaj and Vipin Arora (EIA) discovered. A not very helpful result for traders who deal with oil and USD. The authors have identified different transmission channels which provide simple theoretical underpinnings of the relationship between exchange rates and oil prices. The empirical evidence on the topic suggested that past relationships are not useful to predict future prices. The goal of the study was to discover if past oil price changes based on exchange rates is useful for forecasting oil prices in the future. The conclusion is clear-cut: “there is strong evidence that oil prices and exchange rates are related over the long-run. There is also a fair amount of evidence for various short-run linkages and spillovers between both markets at daily and monthly frequencies. The inverse causality from US dollar depreciations to increases in oil prices often materializes at a daily frequency or over a few months. A fair conclusion is that exchange rate movements are not a silver bullet for understanding or forecasting the price of oil—and vice versa—and neither is a substitute for supply or demand factors.”
Therefore, oil prices are not a good proxy to forecast exchange rate movements, and vice versa, it’s the key message sent to traders. However, the authors explain, “each variable contains potentially useful information for forecasting the other and should be taken into account, particularly over the short-run. The oil price-exchange rate relationship is evolving over time and has recently become more volatile. The change in monetary policy and the financialization of commodity markets offer potential explanations for the intensified relationship.” But things have changed with recent policies taken by central banks, as it must be verified if unconventional monetary policy modifies the intensity of the link.
The three authors have also identified a number of important open questions. “Addressing time-varying predictability and sample choices is quite important since both exchange rates and oil prices are hard to predict. The argument that commodity exporter’s exchange rates might be useful for oil price predictions deserves attention. Disentangling oil supply and demand factors is also quite important since most studies analyze the relationship between the oil price and exchange rate without separating oil demand and supply factors. Such a distinction is of great importance for a theoretical underpinning of the transmission channels from exchange rates to oil prices. The understanding of the exchange-rate pass-through of oil exporters potentially explains the time-varying ties between exchange rates and oil prices. Related to the issue of supply and demand, it also seems quite important to address the role of common factors, such as monetary policy drivers. At a minimum one should include these factors in an empirical investigation, while the optimal solution is an evaluation of potential indirect transmission channels. Policy announcements have been identified as a potential driver of exchange rate volatility and exchange rate expectations, while there has been much less written about their effect on oil prices”, the study concludes.