A good friend of mine posited a very interesting question to me the other day as I was furthering my research into FX forecasting: we can’t predict when OPEC oil policy changes influence the South African Rand or by how much, but this helps us give statistical probabilities for when similar policies could happen and how they’ll impact foreign currency values? Quite an intriguing analogy to my discussion of the previous articles on FX forecasting and it had me dive into the existing literature on the matter and spoiler alert… he’s right and here’s how.
Over the years, numerous studies have ventured into the intricate relationship between price movements and the broader macroeconomic landscape. It all started with James D. Hamilton’s groundbreaking work in 1983 when he delved into the connection between oil prices and the U.S. business cycle. This opened the door to understanding how energy price shocks could potentially trigger recessions in major global economies. Hamilton has then extended that study throughout his academic career and even pointed out a correlation between economic downturns and periods of rising oil prices.
These studies have grown in scope, exploring various dimensions of how oil prices impact our economic world. They’ve investigated their links with real gross domestic product, their influence on stock markets, and their effects on exchange rates. However, it’s important to note that most of these investigations have primarily centered on large and developed countries and may not have the same impacts on emerging markets.
Understanding how oil prices influence exchange rates is a complex yet crucial aspect of global economics. Researchers have delved into this intricate relationship, yielding valuable insights. One study on the real effective exchange rate of the U.S. dollar stands out. They analyzed data from 1972 to 1993 and found that a one percent increase in oil prices led to a 0.51 percent appreciation of the U.S. dollar. There have also been other studies that supported this by showing that a 10 percent surge in oil prices resulted in a 4.3 percent strengthening of the U.S. dollar.
Chinese academics have also employed the use of Hamilton’s seminal work and extended this relationship to China. Their research from 1990 to 2005 revealed a long-term three percent appreciation of the real effective exchange rate with rising oil prices. Similarly, a different study found a 0.2 percent increase in the Fijian dollar’s value for every 10 percent jump in crude oil prices between 2000 and 2006.
Contrastingly, there have also been studies that indicated that increasing oil prices led to depreciating real exchange rates and some studies have provided an alternative perspective, concluding that oil prices had no statistically significant impact on the nominal exchange rate to the USD. However, it should be noted that these studies were done on emerging markets, Kazakhstan and Dominican Republic respectively.
In summary, these studies collectively highlight the multifaceted nature of the relationship between oil prices and exchange rates, underscoring the importance of context and methodology in understanding their interplay. To delve deeper into the relationship between exchange rates and oil prices, I will zero in on two specific variables: the price of Brent crude oil and the nominal exchange rate (both portrayed as returns to ensure stationarity of the time series). Then run the forecasting steps we’ve discussed the last 3 weeks to figure out the right GARCH models to further extend the crude endogenous forecasting I’ve used so far to forecast FX and mitigate any misrepresentations by the model with actual real world know-how.