What Does the Yield Curve Tell Us about Exchange Rate Predictability?

Abstract

Abstract-Since the term structure of interest rates embodies information about future economic activity, we extract relative Nelson-Siegel (1987) factors from cross-country yield curve differences to proxy expected movements in future exchange rate fundamentals. Using monthly data for the United Kingdom, Canada, Japan, and the United States, we show that the yield curve factors predict exchange rate movements and explain excess currency returns one month to two years ahead. Our results provide support for the asset pricing formulation of exchange rate determination and offer an intuitive explanation to the uncovered interest parity puzzle by relating currency risk premiums to inflation and business cycle risks.

International Parity Relations and Economic Shock: Evidence from Swiss Franc Unpegging

“…Secondly, the stimulus plan by ECB was f even furth recovering currency m peg. Chen and Tsang (2013) conclude that the difference between two countries' yield curve can predict exchange rate movements and explain excess currency returns one month to two years ahead.…”

“…Surprisingly, there is a dearth of academic literature on the parity relations' predictability on the short-term spot rates, although decades of exchange rate studies have discovered many well-known empirical puzzles, in essence failing to connect floating exchange rates to their theoretical macroeconomic determinants, or fundamentals (Aliber, 1973;Chen and Tsang, 2013). Frenkel and Rose (1995) offer a comprehensive summary of the various difficulties confronting the empirical exchange rate literature.…”

“…Sarno (2005) and Rogoff and Stavrakeva (2008) present more recent surveys. Because the measurement of market expectations is quite difficult, if not impossible, additional assumptions, such as a linear driving process for the fundamentals, are typically imposed in order to relate the exchange rate to its currently observable fundamentals (Mark, 1995;Engle and West, 2005;Chen and Tsang, 2013 among many others). While Hakkio (1992) argues that the short-term different political and economic shocks could drive the movement of exchange rates, we further extend the idea and maintain that short-term exchange rates can be looked by using the parity relations to understand the probable directional changes of exchange rates influenced by the political and economic shock that impact the movement of the exchange rate of interest.…”

From carry trades to curvy trades

“…We build on the work of Chen and Tsang (2013) and Gräb and Kostka (2018) to investigate to what extent the term structure components level, slope and curvature can help predict exchange rate excess returns in-sample. This exercise does not aim to contribute any substance to the vast literature on exchange rate forecasting, inspired by and subsequent to Meese and Rogoff (1983).…”

Asset Prices and Macroeconomic Outcomes: A Survey

“…Combining monetary fundamentals and policy reaction functions with yield curve factors reflecting expectations and risk premia further helps to explain exchange rate movements and excess currency returns one month to two years ahead, outperforming the random walk (Chen and Tsang (2013)). Conversely, as Engel and West (2005) show, exchange rates are useful in forecasting future monetary policy, consistent with the idea that they reflect market expectations of policy.…”