Exchange Rates and Commodity Prices

One way to test our theory is to see if commodity prices and the exchange rate have been moving in tandem. If we find that they are not moving in tandem, or that they are completely unrelated, we'll know that changes in currency prices are <i>not</i> causing exchange rate fluctuations. If commodity prices and exchange rates do move together, this does not absolutely prove that increased commodity prices are causing changes in the exchange rate, as there could be some other third factor causing them both to move in the same direction. It is, however, pretty strong evidence in support of our theory.

In A Beginner's Guide to Exchange Rates and the Foreign Exchange Market we learned that "The Bank of Canada has developed a Commodity Price Index, which tracks changes in the prices of commodities which Canada exports." The CPI can be broken down into three basic components, which are weighted to reflect the relative magnitude of those exports:

1. Energy: 34.9%
2. Food: 18.8%
3. Industrial Materials: 46.3%
   (Metals 14.4%, Minerals 2.3%, Forest Products 29.6%)

I've collected monthly exchange rate and commodity price index data for 2002 and 2003 (24 months). The exchange rate data comes from the St. Louis Fed - FRED II and the commodity price index data is from The Bank of Canada. The commodity price index data has also been broken down into its three main components, so we can see if any one commodity group is causing the exchange rate fluctuations. The exchange rate and commodity price data for the 24 months can be seen at the bottom of this page.

The first thing to note is how the Canadian Dollar, the commodity price index, and the 3 components of the index have all risen over the 2 year period. In percentage terms, we have the following increases:

1. Canadian Dollar - Up 21.771%
2. Commodity Price Index - Up 46.754%
3. Energy - Up 100.232%
4. Food - Up 13.682%
5. Industrial Materials - Up 21.729%

The commodity price index has risen twice as fast as the Canadian Dollar. The bulk of this increase seems to be due to higher energy prices, most notably higher natural gas and crude oil prices. The price of food and industrial materials has also risen during this period, though not nearly as quickly as energy prices.

We can determine if these prices are moving together, by computing the correlation between the exchange rate and the various CPI factors. The economics glossary defines correlation in the following way:

Two random variables are positively correlated if high values of one are likely to be associated with high values of the other. They are negatively correlated if high values of one are likely to be associated with low values of the other. Correlation coefficients are between -1 and 1, inclusive, by definition. They are greater than zero for positive correlation and less than zero for negative correlations.

A correlation coefficient of 0.5 or 0.6 would indicate that the exchange rate and the commodity price index move in the same direction, whereas a low correlation, such as 0 or 0.1 would indicate that the two are unrelated. Keep in mind that 24 observations is a very limited sample, so we need to take these measures with a grain of salt.

Correlation Coefficients for the 24 months of 2002-2003

• Exch Rate & Commodity Index = .746
• Exch Rate & Energy = .193
• Exch Rate & Food = .825
• Exch Rate & Ind Mat = .883
• Energy & Food = .336
• Energy & Ind Mat = .169
• Food & Ind Mat = .600

We see that the Canadian-American exchange rate is very highly correlated with the commodity price index over this period. This is strong evidence that increased commodity prices are causing a hike in the exchange rate. Interestingly enough, it appears that rising energy prices have very little to do with the rise of the Canadian Dollar, but higher prices for food and industrial materials are playing a big role. Interestingly enough, energy prices hikes do not correlate well with rises in food and industrial materials costs (.336 and .169 respectively), but food prices and industrial material prices do move in tandem (.600 correlation). If anyone has a good theory on why this should be the case, please send me a note. For our theory to hold true, we need the rising prices to be caused by increased American spending on Canadian food and industrial materials. In the final section, we'll see if American truly are buying more of these Canadian goods.

Be Sure to Continue to Page 3 of "Exchange Rates and Commodity Prices"