Unemployment fluctuations and the predictability of currency returns

We investigate if unemployment fluctuations generate predictability in the cross-section of currency excess returns. To assess the predictability exerted by unemployment fluctuations, we sort currencies according to past growth in the unemployment rate. We find that an investment strategy which shorts currencies that experienced high growth in the unemployment rate and invests in currencies that experienced low growth in the unemployment rate, produces positive and sizable excess returns. This strategy improves the performance of the optimal portfolio of the currency investor. Moreover, a principal component analysis suggests an interpretation of this strategy as a risk-factor which drives the variability of portfolio average returns. Asset pricing tests show that popular risk factors in the FX literature are not priced in the cross-section of portfolios sorted on past unemployment fluctuations.