| Since the seminal study of Meese and Rogoff (1983) there was a long-standing exchange rate disconnect puzzle. The only studies that were able to point towards a significant relationship between fundamentals and exchange rates were those analyzing high frequency reactions to surprises in macroeconomic news. These studies are limited to major currencies. Initial analysis on non-major currencies shows a considerable time variation in their response to US nonfarm payroll surprises. Ignoring this time variation leads to the wrong conclusion of a disconnection between fundamentals and exchange rates. We conjecture that for risky currencies investor sentiment regularly dominates fundamentals. We should, therefore, take investor sentiment into account when modeling the link between fundamentals and exchange rates. With this novel approach we will not only better explain the link between exchange rates and fundamentals, but also be able to provide new insights into the impact of investor sentiment on asset prices. When does sentiment dominate fundamentals? Are there prolonged periods sentiment is the main driver of asset prices? Which macroeconomic news announcements have the ability to change sentiment? |
