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Monetary Policy and Currency Returns: The Foresight Saga

Last Updated on 10 February, 2024 by Rejaul Karim

The research study “Monetary Policy and Currency Returns: The Foresight Saga” sheds light on the intriguing interplay between monetary policy changes and currency returns across major economies.

Authored by Dmitry Borisenko and Igor Pozdeev, the paper delves into the documented drift in exchange rates preceding monetary policy adjustments, with currencies showing a tendency to depreciate before policy rate cuts and appreciate before rate increases.

The study demonstrates the feasibility of accurately forecasting monetary policy decisions using available fixed income instruments, consequently making the drift foreseeable and exploitable by investors.

Notably, a straightforward trading strategy based on predicted local interest rate movements yields a statistically significant return, challenging conventional risk-based explanations of exchange rate dynamics. With a focus on monetary policy, policy expectations, predictability, overnight index swap, and foreign exchange, this research paves the way for a deeper understanding of the complex relationship between monetary policy and currency returns.

Abstract Of Paper

We document a drift in exchange rates before monetary policy changes across major economies. Currencies tend to depreciate by 0.7 percent over ten days before policy rate cuts and appreciate by 0.5 percent before policy rate increases. We show that available fixed income instruments allow to accurately forecast monetary policy decisions and thus that the drift is foreseeable and exploitable by investors. A simple trading strategy buying currencies against USD ten days ahead of predicted local interest rate hikes and selling currencies before predicted cuts earns on average a statistically significant return of 42 basis points per ten-day period. We further demonstrate that this return is robust to the choice of holding horizon and monetary policy forecast rule. Our results thus pose a major challenge for the risk-based explanations of the exchange rate dynamics.

Original paper – Download PDF

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Author

Dmitry Borisenko
Independent

Igor Pozdeev
affiliation not provided to SSRN

Conclusion

In conclusion, the study on “Monetary Policy and Currency Returns: The Foresight Saga” presents compelling evidence of the predictable drift in exchange rates preceding monetary policy changes across major economies.

Authored by Dmitry Borisenko and Igor Pozdeev, the research showcases the tendency for currencies to depreciate before policy rate cuts and appreciate before rate increases, highlighting the significant impact of monetary policy on currency returns.

The study’s findings underscore the potential for accurately forecasting monetary policy decisions using available fixed income instruments, thereby creating exploitable opportunities for investors.

Notably, the demonstrated efficacy of a simple trading strategy based on predicted local interest rate movements challenges conventional risk-based explanations of exchange rate dynamics, yielding a statistically significant return and proving to be robust across various scenarios. With its focus on monetary policy, policy expectations, predictability, overnight index swap, and foreign exchange, this research advances our understanding of the nuanced relationship between monetary policy and currency returns.

Related Reading:

The Dollar Ahead of FOMC Target Rate Changes

Safe Haven Currencies: A Portfolio Perspective

FAQ

Q1: What is the main focus of the research study “Monetary Policy and Currency Returns: The Foresight Saga”?

A1: The main focus of the research study is to investigate the relationship between monetary policy changes and currency returns across major economies. The study specifically examines the documented drift in exchange rates that occurs before monetary policy adjustments, with currencies displaying a tendency to depreciate before policy rate cuts and appreciate before rate increases.

Q2: What does the study reveal about the drift in exchange rates before monetary policy changes?

A2: The study documents a consistent drift in exchange rates before monetary policy changes. Currencies tend to depreciate by 0.7 percent over ten days before policy rate cuts and appreciate by 0.5 percent before policy rate increases. This suggests that there is a predictable pattern in exchange rate movements leading up to monetary policy decisions.

Q3: How does the study demonstrate the feasibility of forecasting monetary policy decisions?

A3: The study shows that available fixed income instruments allow for accurate forecasting of monetary policy decisions. Investors can use these instruments to predict upcoming policy rate changes, making the drift in exchange rates foreseeable and exploitable. The research suggests that investors can gain insights into monetary policy changes by analyzing fixed income markets.

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