US Interest Rate Surprises and Currency Returns

Centre for Endowment Asset Management (CEAM)
Centre for Endowment Asset Management (CEAM)

Overview

When the US Federal Reserve announces interest rate decisions, financial markets around the world react within minutes. This project studies how those US monetary policy surprises affect different currencies, and why some currencies systematically earn higher returns than others around these events. 

Tablet screen showing financial graphs.

Authors

Lucio Sarno

Cambridge Judge Business School, University of Cambridge

Gino Cenedese

Juan Antolin-Diaz

Assistant Professor of Finance at MIT

Shangqi Han

About the research

The starting point is that not all “rate surprises” are the same. A change in interest rates around a Federal Open Market Committee (FOMC) announcement can reflect two distinct pieces of news: 

  • A pure monetary policy shock: the Fed tightens or loosens policy more than expected. 
  • A central bank information shock: the Fed reveals new information about the economic outlook (for example, that growth will be stronger than previously thought), which can move both interest rates and stock prices in the same direction. 

Using high frequency data on US interest rates and equity futures in a 30 minute window around FOMC announcements, the research separates these two types of shocks by looking at how interest rates and stock prices move together. It then measures how 16 major currencies respond to each type of shock. 

Findings

The research shows that: 

  • Currencies differ widely in how sensitive they are to US monetary policy and information shocks. 
  • This sensitivity is systematically related to country characteristics, such as: Net foreign asset positions (net borrowers vs net lenders), Trade network centrality, Interest rate and inflation differentials, Exposure to global equity risk, and Long run growth prospects. 

Based on these characteristics, the research builds exposure indices that summarise how much each currency is exposed to US policy and information shocks at each point in time. Sorting currencies on these indices, the researchers construct long–short portfolios that buy currencies most exposed to US policy risk and sell those least exposed. 

These strategies: 

  • Earn economically and statistically significant excess returns, even after controlling for standard currency factors such as dollar, carry and momentum. 
  • Generate most of their profits on FOMC days, consistent with being rewarded for bearing US monetary policy risk. 

This project offers a rich example of how to combine: 

  • High frequency identification of macro shocks, 
  • Cross sectional asset pricing, and 
  • Economic fundamentals (trade, external balance, growth, risk). 

It highlights how US monetary policy shapes global currency returns, and how exposure to that risk can be measured and priced.

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