US Fiscal Cycle and the Dollar
55 Pages Posted: 6 Dec 2018
Date Written: January 24, 2019
When the US fiscal condition is strong, the dollar is strong, has a high forward discount, and continues to appreciate in the next 2 years. I propose a framework to decompose the dollar's real exchange rate into cash flows and risk premia, and show these patterns imply that a stronger US fiscal condition lowers the dollar's short-run risk premium but raises its long-run risk premium. Since the dollar's risk premia reveal information about the US investors' pricing kernel, the US fiscal cycle further explains the term structure of US equity risk premia, bond risk premia, and cross-border capital flows. These results highlight the US fiscal cycle as the key variable for understanding not only the dollar but also the US investments' risk premia.
Keywords: The dollar, fiscal cycle, term structure of risk premium
JEL Classification: F31, G10
Suggested Citation: Suggested Citation