Macro fundamentals predict currency returns

Congratulations Magnus Dahlquist whose paper “Economic momentum and currency returns” written with Henrik Hasseltoft was recently accepted for publication in the Journal of Financial Economics.

Economic models suggest a strong link between economic fundamentals and exchange rates. However, academics and practitioners have struggled to find such a link.  Instead, they have documented cross-sectional and time-series predictability of exchange rates in the form of carry, momentum, and value strategies.  However, it is still widely debated what economic risks, if any, these investment strategies represent.

Magnus Dahlquist and Henrik Hasseltoft find that macro fundamentals do predict currency returns. More specifically, past trends in fundamental variables linked to economic activity and inflation predict currency returns.  A trading strategy that goes long currencies with strong economic momentum and short currencies with weak economic momentum exhibits an annualized Sharpe ratio of 0.70 and yields a significant alpha when controlling for standard carry, momentum, and value strategies. The economic momentum strategy subsumes the alpha of carry trades, suggesting that the standard currency carry trade is captured by differences in past economic trends.