Exchange rates and the yield curve exchange rates and the yield curve

In financial markets, folk wisdom holds that a country's currency appreciates when its interest rates increase relative to that of other countries. The relationship is contemporaneous and yields are often perceived to be driven by monetary policy - both conventional and unconventional. In this paper, the authors systematically dissect the empirical contemporaneous link between yields and exchange-rate fluctuations at a quarterly frequency, relying on a parsimonious model based on VAR-based expectations of short-run yields and inflation. The authors also rely on the assumption that the real exchange rate is stationary, which seems to be supported by the data. They consider 10 liquid currencies whose government debt is risk free and study currency pairs with respect to three base currencies - the U.S. dollar, the British pound, and the euro. Then, to better understand the drivers of the patterns they find, the authors use expectations implied by an estimated vector autoregression to decompose both yields/forwards and exchange-rate changes into components relating to interest rate expectations, exchange rate expectations, currency excess returns, or term premia.