Exchange rates are pulled about by countless factors. There is a tendency to focus on standard fundamentals that happened to coincide with recent exchange rate moves. This has given rise to the “scapegoat theory of exchange rates”. It is nicely explained in a recent Bank of Italy paper. It implies caution in respect to popular “FX themes” in broker research that may lead to distortions, crowded positions and setback risk.

Fratzscher, Marcel, Dagfinn Rime, Lucio Sarno and Gabriele Zinna (2014), “The scapegoat theory of exchange rates: the first tests”, Temi di discussione (Economic working papers) from Bank of Italy, no. 991, October 2014.

The below are excerpts from the paper. Emphasis and cursive text have been added.

The scapegoat theory

“There is ample anecdotal evidence that financial market participants tend to blame individual macro fundamentals to rationalize observed exchange rate movements, with such blame often shifting across different fundamentals over time.”

“The essence of the scapegoat theory of exchange rates is that at times some macroeconomic factors receive an unusually large weight and thus are made scapegoats of exchange rate movements. This scapegoat effect arises because of agents’ rational confusion as they make inference on the true parameters of the model only conditioning on observable fundamentals and exchange rate movements at times when the exchange rate is instead driven by unobservables (e.g. large order flows)…This implies that when currency movements over the short to medium term are inconsistent with their priors about the underlying structural relationships, agents search for scapegoats to account for these inconsistencies. Such currency movements may be driven by unobservable fundamentals, yet for agents it is rational to assign additional weight to some observable fundamentals, thus making them scapegoats for exchange rate changes.”

“The FX market sometimes seems like a serial monogamist. It concentrates on one issue at a time, but the issue is replaced frequently. Dollar weakness and US policy have captured its heart. But uncertainties are being resolved… The market may move back to an earlier love …” [Financial Times, November 8, 2010]

“The scapegoat theory states that a macro fundamental may become a scapegoat if there is a sizable shock to the unobservable fundamental, and at the same time the size of the deviation of the macro fundamental from its equilibrium is large and theoretically consistent with the observed direction of change in the exchange rate…A particular macroeconomic variable is more likely to become a scapegoat the larger the (unexplained) FX rate movement and the more this particular fundamental is out of line with its long-run equilibrium. Over the short run, both the scapegoat fundamental as well as the unobservable fundamental may thus help explain FX movements.”

The evidence

“This paper provides the first empirical test of the scapegoat theory of exchange rates, exploiting novel data on exchange rate scapegoats from surveys as well as proxies of unobservable fundamentals based on FX order ow for a sample of 12 exchange rates over the 2000-2011 period…Exchange rate scapegoats stem from monthly surveys of 40-60 financial market participants, who are asked to rate on a quantitative scale the importance of six key variables (short-term interest rates, long-term interest rates, growth, inflation, current account, and equity flows) as drivers of a country’s exchange rate vis-a-vis its reference currency. This survey data allows us to extract quantitative scapegoat measures for each of these six fundamentals over time and across currencies…Further, FX order flow data proxies for unobservable factors driving exchange rates since order flow contains information that is not public given the over-the-counter institutional features of the FX market and is empirically powerful in explaining exchange rate movements, as documented in a vast literature on FX microstructure.”


“Overall, the empirical evidence provides strong support in favor of the scapegoat theory of exchange rates…The scapegoats add explanatory power to macroeconomic and order flow information…a macroeconomic fundamental is picked and identified by market participants as a scapegoat at times when (i) the unobservable fundamental experiences a large shock, (ii) the observable fundamental tends to show a large deviation from its long-term equilibrium, and (iii) moves in a direction that is consistent with the observed movement in the exchange rate.”

The consequences

“This scapegoat effect can generate an unstable relationship between exchange rates and macro fundamentals, driven mainly by the expectation of the structural parameters and not by the structural parameters themselves.”

“A key insight of the [scapegoat] theory is that the derivative of the exchange rate with respect to the fundamentals can be disconnected from the true underlying structural parameters in the short to medium term. In particular, this effect takes place when a macro fundamental receives an unusually large weight, and therefore is made the scapegoat for exchange rate changes. However, as a result of the investors’ learning process, the expectation of the structural parameter should converge to the structural parameter in the long run.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.