BoC: USD multilateral Moves Better Predict USD/CAD Than Commodity Prices

Bank of Canada staff concluded in a Monday research paper on the Predictive Ability of Commodity Prices for the Canadian Dollar, that USD multilateral fluctuations better predict CAD-USD movements than do commodity prices, although the latter are "important drivers" of the loonie.

"While commodity prices (energy and non-energy) are indeed important drivers of the CAD, the USD multilateral factor has stronger predictive ability, suggesting that exchange rate co-movements best explain the variations in the CAD-USD exchange rate," said the analytical note.

The paper found that energy and non-energy commodity prices are better at explaining short-term moves than longer-term ones.

"We have confirmed that energy and non-energy commodity prices are useful for explaining contemporaneous variations of the Canadian dollar," said the note produced by Kimberly Berg, Pierre Guerin and Yuko Imura. "Specifically, we find that commodity prices have significant explanatory power for the CAD-USD nominal exchange rate at the daily frequency."

That being said, "their statistical significance for both point forecasts and directional accuracy is found to diminish at lower frequencies, suggesting that their correlation with the exchange rate is more pronounced in the short run."

The report pointed out that commodity prices are subject to temporary shocks, "in that commodity prices exhibit very little persistence. As a result, at a lower frequency, the statistical significance of the informational content of commodity prices for the CAD-USD exchange rate tends to diminish."

Instead, when looking at what the analysts called "success ratios" - indicating the proportion of times the model correctly predicts a CAD depreciation or appreciation against the greenback - the staff found that "the model with the USD multilateral factor yields the highest success ratios, and the interest rate differential yields the lowest success ratios among the four predictors."

The staff looked at energy commodity prices, non-energy commodity prices, Canada-U.S. rate differential based on the BOC overnight rate and the U.S. 3-month commercial paper rate, and the USD multilateral factor representing co-movements of exchange rates.

"As such, the USD multilateral adjustment factor captures macroeconomic and financial developments affecting the overall strength of the USD, which are not necessarily related to economic developments in Canada."