A new IMF paper suggests that there is much more to exchange rate dynamics in “risk-off” periods than correlation-driven risk shedding. Indeed, it provides evidence that economic fundamentals, particularly external balances, re-assert themselves precisely during the first twelve weeks after market turmoil has erupted, when the asking price for incremental economic and policy risk is steep.

“The Behavior of Currencies during Risk-off Episodes”, Reinout De Bock and Irineu de Carvalho Filho, IMF WP 12/8


The paper starts out with the obvious: “Currency markets exhibit recurrent patterns during risk-off episodes, as the Japanese yen, Swiss franc, and U.S. dollar (USD) tend to appreciate against other G-10 and emerging market currencies, be it 1-week or 12-weeks after the start of a risk-off episode. In particular, returns of emerging markets (EM) currencies vis-à-vis the USD exhibit a high degree of correlation during and across these episodes.”

Yet the authors find something more profound behind the pattern:  “the cross-section behavior of bilateral exchange rates with respect to the USD can be linked to information on policy interest rates and balance of payments dynamics available prior to the risk-off episode. The predictability of spot returns conditional on entering a risk-off episode suggests that two non-exclusive mechanisms may be at play. Investors may reassess the riskiness of each currency in light of a changing global environment (new information) or reprice risky assets in general (new price of risk).”

“Risk-off episodes have become more frequent and severe since the beginning of the Global Financial Crisis in the summer of 2007, after a few years of relatively calm markets. We find no substantial difference over time in the role of fundamentals associated with the balance of payments or international investment position.”
Most of the research is based on simple regression analysis of plausible relations between fundamentals and exchange rates in periods of heightened risk aversion: “Our research shows that lower policy rates, stronger current account balances, and stronger net foreign asset or reserve asset positions are factors related to smaller risk-off depreciations or larger appreciations. Deviations of actual exchange rates from measures of equilibrium levels also matter, as overvaluation in two of the three models of the IMF‟s Consultative Group on Exchange Rates (CGER) makes currencies more vulnerable in risk-off episodes. Market characteristics also help to explain FX performance during risk-off episodes, as less liquid currencies, as measured by bid-ask spreads and restrictions on international capital flows, tend to weaken during risk-off episodes…all variables are available prior to the risk-off episode.”
·     “Policy interest rate before the episode: High interest rate currencies tend to be on the receiving end of carry trade and portfolio flows. Market conditions that cause a pullback or slowdown in these flows would weaken high interest rate currencies. It is worth noting that policy interest rates are often set in response to developments in the domestic economy…[According to regression analysis] high yielding currencies tend to depreciate more in the six weeks following the onset of a risk-off episode, which is likely related to disruptions in carry trade positions.”
·     “Lagged current account balance: The availability of financing of current account deficits may become more restrictive in risk-off episodes, so we expect larger depreciations in countries with larger deficits during such episodes…[In regressions] higher current account balances are correlated with appreciation over all [1-12 months] horizons.”
·     “Net foreign asset position: A country with a large positive net foreign asset position (or reserves) is less likely to run into problems servicing its external debt or face liquidity shortages that lead to currency sell-offs. In particular, a larger stock of reserves relative to short-term liabilities can help to defend the exchange rate level during risk-off episodes. ..[In regressions] stronger net foreign asset positions are correlated with appreciation over all horizons.”
·     “Recent foreign portfolio inflows (4 quarters MA, percent of GDP). This variable captures a country‟s higher vulnerability to FX weakness following a sharp increase in debt or equity flows. Even if there are no outflows during the risk-off episodes, currencies could still depreciate as investors hedge the local currency exposure on their bond holdings…[In regressions] countries that have seen stronger foreign portfolio inflows in the run-up to a risk-off episode are more vulnerable to FX weakness for horizon of 6 weeks or longer.”
·     “Measures of exchange rate misalignments. Risk-off episodes may trigger exchange rate adjustments that close the gap between actual real exchange rates and measures of equilibrium exchange rates. We use three measures of exchange rate misalignments estimated by the IMF‟s Consultative Group on Exchange Rates (CGER). The Macroeconomic Balance (MB) approach compares deviations from current account balances from current account norms. The Equilibrium Real Exchange Rate (ERER) approach evaluates deviations from real effective exchange rates from the levels implied by a panel cointegration regression. Finally, the External Sustainability (ES) approach focuses on consistency between current account balances and a stable ratio of net foreign assets to GDP…[In regressions] theMB and ES frameworks show a link between overvaluation and risk-off depreciations, unlike the Equilibrium Real Exchange Rate approach.”
·    “Bid-ask spread: The bid-ask spread captures the ease at which investors can unwind or build positions in a currency….[In regressions] bid-ask spreads are not associated with risk-off depreciations on impact, but tend to be positively correlated with risk-off depreciations over 12 weeks. In addition, currencies from countries where capital flows are less restricted- as indicated by the Chinn-Ito index of capital liberalization- are less prone to FX weakness during risk-off episodes.”  
The existence of recurrent patterns in the cross-section of currency returns suggests that certain fundamental-based currency strategies could generate extraordinary profits, as explored by Nozaki (2010) and Jordà and Taylor (2012). In a result analogous to the findings of this paper, Melvin and Taylor (2008) argue that conditioning the carry trade on a global financial stress index would have been a winning strategy during the Global Financial Crisis.