Can Detrended Oil Prices Predict Currency Returns?

Abstract

Exchange rate forecasting has long been considered as a puzzle. With the acceleration of the financialization in crude oil market, increased speculation leads to more unusual volatility in oil prices, which finally results in the oil prices providing information about future economic fundamentals that contains lots of noise. In our study, we provide a feasible approach to solving the puzzle by introducing a detrended predictor based on the standardized fitted residual of oil prices. Empirical results show that it can generate significant predictive power for currency returns in Canada, New Zealand and South Africa both in- and out-of-sample. In addition, the trading strategies based on the detrended predictor can generate higher economic significance.