Yield curve shapes and foreign exchange rates: the term structure of interest rates model approach

Exchange rates play a crucial role in the international economy. This study investigates the explanatory power of yield curve factors in exchange rate predictions for countries in three currency pairs: Japanese yen (JPY)–US dollar (USD), British pound (GBP)–USD, and Canadian dollar (CAD)–USD. The results empirically establish that each country’s yield curve factors, extracted from the term structure of interest rates model, play a key role in determining future exchange rates. Specifically, an increase in the US level factor causes depreciation in the USD relative to the JPY for the full sample period (June 1994–October 2020) and in the GBP and CAD for the post-global financial crisis period. The study’s model provides more useful information than the baseline uncovered interest rate parity model for explaining the variations in the three currency pairs. Additionally, the yield curve factors also explain the variation in countries’ excess currency returns. This study has important theoretical implications for identifying which of the two countries’ yield curve factors predominantly explain the exchange rate changes and the related policy implications. It also provides key policy insights by substantiating the association between macroeconomic variables and exchange rate changes.