Catching the Elusive Exchange Rate-Interest Rate Correlation

In this paper, I show that sign and magnitude of the contemporaneous exchange rates-interest rate (ER-IR) correlation are predictable, across countries and through the risk cycle. I discuss the correlation smile, whereby the ER-IR correlation for countries at both extremes of the risk spectrum are large, and comove with proxies of systematic risk, whereas those in the middle remain comparatively smaller and flatter through the cycle. Picking a base currency at either extreme of the spectrum makes appear a communicating vessel effect between riskiest and safest currencies, while picking one in the middle shifts the emphasis towards the compression-decompression between EM and DM. While the default behavior of EM central banks has been to let real interest rates passively absorb some of the FX risk premium – producing the characteristic negative correlation – some have instead set real rates in a way to deliberately strengthen or weaken the currency, producing a positive ER-IR correlation, with real rates reasserting their driving role within the exchange rate pricing relation