US Fiscal Cycle and the Dollar
50 Pages Posted: 6 Dec 2018
Date Written: December 6, 2018
When the US fiscal condition is strong, the dollar is strong and continues to appreciate against foreign currencies in the next 3 years. This pattern is unique to the US, explaining 50% of the low-frequency variation in the dollar's value and absorbing the return predictability of the forward premium. In a model with sticky prices, I show this pattern is driven by the comovement between the US fiscal cycle and the US investors' risk appetite: During US expansions, higher US government surpluses increase the nominal value of the dollar, while less risk-averse US investors require lower returns to hold foreign currencies. Consistent with this view, the US fiscal cycle also explains the term premium, the dollar carry trade, the currency return momentum, and the US investors' capital flows.
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