Forecasting Exchange Rates with Generalized Principal Components

We extract principal components from a panel of 17 exchange rates and use the deviations from the components to forecast future exchange rate movements, following the idea in Engel, Mark, and West (2015). Instead of using the standard method, we apply a generalized principal components analysis that captures temporal and cross-sectional variation and covariation among the exchange rates. We find that the method dominates forecasts by existing standard methods and random walk, with or without including macroeconomic fundamentals