Why Does the Australian Dollar Move so Closely with the Terms of Trade?

Economic Group Reserve Bank of Australia We thank participants at a Reserve Bank seminar and Adrian Pagan for comments. We are very grateful to John Simon for performing the Monte Carlo simulations in the paper. The views expressed are those of the authors and should not be attributed to the Reserve Bank of Australia. Abstract The paper is motivated by two empirical results. Australia's terms of trade exhibit temporary fluctuations around a slowly declining trend, and movements in Australia's real exchange rate tend to follow those in the terms of trade. Together these results imply predictability in Australia's real exchange rate as well as the presence of predictable excess returns that are sometimes quite large. Using a simple econometric model, with the terms of trade as the sole explanator, the paper demonstrates the forecastability of Australia's real exchange rate over horizons ranging from one to two years. It then quantifies the magnitude of the predictable excess returns to holding Australian dollar denominated assets over such horizons, finding them to be highly variable and sometimes quite large in magnitude. The results suggest a relative scarcity of forward-looking foreign exchange market participants with an investment horizon of a year or more.