Exchange Rate Reconnect

Abstract

The failure to find fundamentals that co-move with rates or forecasting models with even mild predictive power â?? facts broadly referred to as exchange rate disconnect â?? stands among the most disappointing, but robust, facts in all of international macroeconomics. In this paper, we demonstrate that U.S. purchases of foreign bonds, which did not co-move with rates prior to 2007, have provided significant in-sample, and even some out-of-sample, explanatory power for currencies since then. We show that several proxies for global risk factors also start to co-move strongly with the dollar and with U.S. purchases of foreign bonds around 2007, suggesting that risk plays a key role in this finding. We use security-level data on U.S. portfolios to demonstrate that the reconnect of U.S. foreign bond purchases to rates is largely driven by investment in dollar-denominated assets rather than by foreign currency exposure alone. Our results support the narrative emerging from an active recent literature that the US dollar's role as an international and safe-haven currency has surged since the global financial crisis.