US Fiscal Cycle and the Dollar Wednesday, 19 December, 2018

A new research paper related mainly to:

#129 - Dollar Carry Trade
#8 -
FX Momentum

Authors: Jiang

Title: US Fiscal Cycle and the Dollar

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3278339

Abstract:

When the US fiscal condition is strong, the dollar is strong and continues to appreciate against foreign currencies in the next 3 years. This pattern is unique to the US, explaining 50% of the low-frequency variation in the dollar's value and absorbing the return predictability of the forward premium. In a model with sticky prices, I show this pattern is driven by the comovement between the US fiscal cycle and the US investors' risk appetite: During US expansions, higher US government surpluses increase the nominal value of the dollar, while less risk-averse US investors require lower returns to hold foreign currencies. Consistent with this view, the US fiscal cycle also explains the term premium, the dollar carry trade, the currency return momentum, and the US investors' capital flows.

Notable quotations from the academic research paper:

"The US fiscal cycle lines up with the dollar's value and future return against foreign currencies. Figure 1 plots the US government surplus-to-debt ratio along with the dollar index and the dollar's excess return against foreign currencies in the following 4 quarters. The surplus-to-debt ratio measures the net fraction of its outstanding debt the US government pays down in each quarter, reflecting a slow-moving fiscal cycle. Since the late 1980s, a higher US government surplus-to-debt ratio corresponds to a stronger dollar today and predicts a higher expected return on the dollar in the future.

us dollar cycle

This finding is also unique to the US: Higher government surplus-to-debt ratios do not correlate with higher nominal exchange rates in 8 out of 10 other developed countries, and do not predict higher currency returns in 9 out of 10 other developed countries.

I conjecture that this relationship between the US fiscal cycle and the dollar is driven by two mechanisms. On the one hand, the fiscal theory of the price level shows that currency value reflects the present value of government surpluses. When the US government surpluses are higher, the dollar is stronger. On the other hand, higher US government surpluses indicate US expansions. During expansions US investors require a lower compensation for holding foreign currencies. As foreign currencies have a lower risk premium with respect to the dollar, the dollar has a higher expected return with respect to foreign currencies.

The fiscal theory mechanism a ects the dollar's nominal value, whereas the risk premium mechanism a ffects the dollar's real return. Price stickiness is required to connect the nominal and the real exchange rates. In a reduced-form new-Keynesian model, I derive the dollar's real exchange rate as future cash flows minus future expected returns. Higher government surpluses increase the dollar's cash flows, whereas a lower risk premium of the US investors increases the dollar's expected returns against foreign currencies. In this way, the dollar is a special asset whose cash flow is positively correlated with its expected return. When the US fiscal condition is stronger, the dollar has a higher valuation and a higher expected return.

Because the US investors' risk premium also a ffects other asset returns and capital flows, the comovement between the US fi scal cycle and the risk premium has broader implications. Indeed, it provides an organizing principle for the following asset pricing phenomena:

First, the forward premium puzzle finds that a higher forward premium of the dollar predicts a higher excess return on the dollar in the short run.

Second, a higher US government surplus-to-debt ratio is associated with a lower term premium and a lower Cochrane and Piazzesi (2005) bond factor, both of which measure the risk premium of long-term US government bonds.

Third, Lustig, Roussanov and Verdelhan (2014) construct a dollar carry trade that buys foreign currencies against the dollar whenever the dollar's forward premium is below 0, and shorts foreign currencies against the dollar otherwise. Since the US government surplus-to-debt ratio comoves with the dollar's forward premium, I construct currency portfolios that exploit the time-series variation in the surplus-to-debt ratio. These portfolios have similar Sharpe ratios and explain the abnormal return of the dollar carry trade, providing evidence for the out-of-sample return predictability of the surplus-to-debt ratio.

Fourth, Burnside, Eichenbaum and Rebelo (2011) find momentum e ects in currency returns. My model shows that when the US government fiscal condition improves, the dollar appreciates and is expected to have a higher return in the future. In this way, the US fiscal cycle drives the common variation in past and future currency returns. Consistent with this result, past currency returns no longer predict future currency returns once I control for the US government surplus-to-debt ratio."


Are you looking for more strategies to read about? Check http://quantpedia.com/Screener

Do you want to see an overview of our database of trading strategies? Check https://quantpedia.com/Chart

Do you want to know how we are searching new strategies? Check https://quantpedia.com/Home/How

Do you want to know more about us? Check http://quantpedia.com/Home/About


Follow us on:

Facebook: https://www.facebook.com/quantpedia/

Twitter: https://twitter.com/quantpedia