Commodity Returns Co-movement and Its Relationship With Uncertainty Shock and the U.S. Dollar Exchange Rate

This study examines the time-varying effects of uncertainty shocks on the broadbased movement of commodity returns since the early 1990s. We employ a vector autoregression (VAR) augmented dynamic factor model with time-varying parameters and stochastic volatility (TVP-VAR-DFM-SV) to extract a common factor from 43 commodity returns. We then create interactions with observed variables, including the U.S. short-term interest rate, excess bond premium, global demand indicator, and the U.S. dollar exchange rate. We identify exogenous uncertainty shocks using an external instrumental variable method. We document an increasing contribution of the common factor to commodity returns since the mid-2000s and find that uncertainty shocks decrease commodity returns across the board. While the negative impact is significant during most periods, its magnitude varies substantially over time, tending to grow much stronger during recessions. Interestingly, uncertainty shocks often lead to dollar appreciation, and thus can potentially account for the seemingly negative correlation between commodity returns and the strength of the U.S. dollar