Inattentive Search for Currency Fundamentals

Abstract

We show how economic agents' limited attention can account for the time-varying link between exchange rates and economic fundamentals. We demonstrate that the higher is the attention for a certain fundamental, the higher is its predictive power in forecasting future currency movements. We proxy attention for a fundamental by its search intensity on Google. In a sample of fifteen bilateral exchange rates from 1995 to 2016, we find that the fundamentals selected by the Google Trends Index significantly outperform the random walk, both statistically and economically. The size of economic profits are considerable: an equally-weighted portfolio earns 4.9% with a Sharpe ratio of 1.3. The highest performance is delivered by strategies that select the single fundamental that receives the highest attention, confirming the limited attention hypothesis.

Keywords: exchange rate forecasting, forex investment strategies

JEL Classification: F31, F41, E44