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US Fiscal Cycle and the Dollar

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “US Fiscal Cycle and the Dollar” by Zhengyang Jiang offers a thought-provoking exploration into the interplay between the US fiscal cycle and the dollar’s performance against foreign currencies.

The study reveals a compelling insight: a stronger fiscal condition in the U.S. significantly foretells higher excess returns on the dollar vis-à-vis foreign currencies in the subsequent year, particularly against foreign currencies exhibiting higher dollar betas.

Notably, this forecasting power is not replicated when considering stronger foreign fiscal conditions. The research posits an intriguing explanation rooted in the unique role played by U.S. government debt as reserve assets.

When the U.S. fiscal condition weakens, the reserve constraint of financial intermediaries tightens, sparking a flight to the dollar and engendering imbalances in capital flows. This, in turn, drives global risk premia, exerting an impact on both the dollar and foreign currencies.

Abstract Of Paper

A stronger US fiscal condition predicts a higher excess return on the dollar against foreign currencies in the following year, and more so against foreign currencies with higher dollar betas. A stronger foreign fiscal condition does not have such forecasting power. These findings can be explained by the unique role the US government debt plays as reserve assets. When the US fiscal condition deteriorates, financial intermediaries’ reserve constraint tightens and triggers a flight to the dollar, creating imbalances in capital flows and driving global risk premia that affect both the dollar and foreign currencies.

Original paper – Download PDF

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Author

Zhengyang Jiang
Kellogg School of Management – Department of Finance; National Bureau of Economic Research (NBER)

Conclusion

In conclusion, the research paper “US Fiscal Cycle and the Dollar” by Zhengyang Jiang underscores the profound relationship between the US fiscal cycle and the dollar’s performance against foreign currencies.

The study compellingly highlights that a robust fiscal condition in the U.S. precisely forecasts elevated excess returns on the dollar relative to foreign currencies in the ensuing year, particularly against those currencies exhibiting higher dollar betas.

This predictive power is notably absent in the case of stronger foreign fiscal conditions. The research’s captivating explanation, hinging on the unique role of U.S. government debt as reserve assets, underscores how a weakened U.S. fiscal condition triggers a flight to the dollar, leading to imbalances in capital flows and influencing global risk premia, thereby shaping the dollar and foreign currencies.

These insights offer a novel perspective on the intricate dynamics between fiscal conditions and currency movements, with implications for understanding and navigating global financial markets.

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FAQ

Q1: What is the main focus of the research paper “US Fiscal Cycle and the Dollar” by Zhengyang Jiang?

A1: The main focus of the research paper is to explore the relationship between the U.S. fiscal cycle and the performance of the U.S. dollar against foreign currencies. Specifically, the study investigates how the fiscal condition of the U.S. can predict excess returns on the dollar in the subsequent year, particularly concerning foreign currencies with higher dollar betas.

Q2: What does the research reveal about the forecasting power of U.S. fiscal conditions on the dollar’s performance against foreign currencies?

A2: The research reveals that a stronger fiscal condition in the U.S. has significant forecasting power. It predicts higher excess returns on the U.S. dollar against foreign currencies in the following year. The predictive power is particularly pronounced when considering foreign currencies that exhibit higher dollar betas. However, the forecasting power is not observed when examining stronger fiscal conditions in foreign countries.

Q3: What explanation does the research provide for the observed relationship between U.S. fiscal conditions and the dollar’s performance?

A3: The research posits a unique explanation rooted in the role of U.S. government debt as reserve assets. When the U.S. fiscal condition deteriorates, the reserve constraint of financial intermediaries tightens. This tightening triggers a flight to the U.S. dollar, creating imbalances in capital flows. These imbalances, in turn, drive global risk premia, influencing both the U.S. dollar and foreign currencies.

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