Exchange rates and the yield curve

In this paper, we confront the data with the financial markets folk wisdom that an increase in a yield or forward rate of country i relative to j is associated with a contemporaneous appreciation of currency i. We find that while the folk wisdom prior to 2009:Q1 holds fairly well for all maturities and three major currency bases, the “coefficient curve” twisted during the zero-lowerbound period so that the relationship became stronger at the short end but weaker and even of the opposite sign at the long end of the curve. We attribute the structural breaks at the short end of the curve to a change in the relationship between expected excess currency returns and changes in relative yields/forwards. The breaks at the long end of the curve can be explained by changing relationships between yields/forwards and the part of exchange rate fluctuations due to changes in expectations over future short-term rates and long-run relative price levels. Alternatively, the twist of the coefficient curve can be attributed to the changing relationship between the exchange rate and the expectations hypothesis component of yields/forwards at the short end and the term premium component at the long end.