The oversight on the relationship between monetary policy setting and exchange rate through yield curve modeling

This study explores the dynamic relationship between the parameters of the yield curve, macrofinancial variables, and the USD/TRY exchange rate in Türkiye, with a particular focus on the period following the steep 2018 currency depreciation. Using the Nelson–Siegel model, we examine the influence of the factors of the yield curve, the level, the slope and the curvature, together with the FX deposits and the Türkiye CDS rate, which serve as proxyes for currency substitution and credit (sovereign) risk, respectively. The initial results of the dynamic linear regression demonstrate that the yield curve parameters provide limited explanatory power, particularly in the context of the volatile macroeconomic environment in Türkiye. However, incorporating FX deposits and CDS rates significantly improves the performance of the model, allowing the capture of key drivers of exchange rate volatility. Additionally, quantile regression is applied to uncover the non-linear and heterogeneous effects of these variables across different segments of the exchange rate distribution. The results show that the impact of yield curve parameters, currency substitution, and systemic credit risk intensifies during periods of market stress, underscoring the importance of taking into account varying market conditions in exchange rate analysis. The findings highlight the need for comprehensive and adaptive models that integrate both short-term financial pressures and long-term structural factors to better understand and manage exchange rate dynamics in emerging markets such as Türkiye.