Rethinking macroeconomics: how G5 currency markets have responded to unconventional monetary policy

The G5 carry trade, where high interest rate currencies appreciate and low interest rate currencies depreciate, had been a persistent anomaly in financial markets since the collapse of Bretton Woods in 1971. Conventional economics said that the reverse should happen: low interest rates were supposed to stimulate the domestic economy, leading to growth and currency appreciation, rather than fund cross-border positions in search of higher yields. The Global Financial Crisis resulted in a major dislocation of currency markets, after which the G5 carry trade reversed. This paper is an empirical study of this reversal, and the implications for macroeconomic theory. Using overnight and one-month carry trades as a proxy for market reactions to monetary policy, the period leading up to the Global Financial Crisis and this reversal was increasingly subdued: the so-called ‘Great Moderation’. Financial crises show up as outliers in the data: temporary reversals of the carry trade during which periods central banks provide additional liquidity in the form of lower interest rates. These results suggest that, prior to 2008, conventional monetary policy – using high/low interest rates to dampen/boost growth and inflation – was being counteracted by capital flows in the opposite direction, in search of high yields. Only since 2008, with unconventional monetary policy – QE, negative interest rates and a reduction in banks’ proprietary trading – have G5 currencies responded as predicted by conventional economics: low/high interest rates G5 currencies have appreciated/depreciated. The results suggest that macroeconomic theories need to be reconsidered, to take account of cross-border capital flows in search of yield, and the effectiveness of unconventional monetary policy.