Currency Return Dynamics: What Is the Role of U.S. Macroeconomic Regimes?

This paper examines how changes in U.S. macroeconomic conditions affect the underlying factors that drive currency return dynamics. The study adopts a tree-based Bayesian regime-switching model that identifies shifts in currency return dynamics instrumented by macroeconomic variables. The empirical analysis finds strong evidence of regime changes in the currency risk-return relationship, which are determined interactively by U.S. inflation and interest rates. The carry factor is identified as a common and dominant factor across all regimes, generating a high risk premium and selection probability, while other factors are regime-specific.