Looking Under the Hood of Commodity Currency Predictability

This paper revisits the exchange rate predictability of commodity currencies through the lens of market efficiency. Focusing on currencies with strong contemporaneous exposure to commodity prices, we show that changes in country-specific commodity export or import prices predict exchange rate fluctuations both in sample and out of sample. We establish four empirical facts: (i) the sign of the predictive relationship runs counter to standard risk-based explanations; (ii) predictability is concentrated at short horizons; (iii) predictability is driven by a small set of thinly traded currencies; and (iv) even sophisticated speculative traders adjust positions sluggishly in response to commodity price shocks in these currencies. Together, these findings suggest that predictability arises from the slow incorporation of information in less actively traded currencies, which is likely due to liquidity and position-building constraints, rather than from compensation for risk. The results also clarify the sources of commodity-based predictability in carry trade returns.

This paper was accepted by Lukas Schmid, finance.

Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2024.07249.