Herding the Scapegoats : Foreign Exchange Order Flow and the Time-Varying Effect of Fundamentals

The poor performance of macroeconomic exchange rate models in and out-of-sample is well documented in literature. One reason for this result is the impact of ‘scapegoat' effects: that is, participants attach different weights to different macro fundamentals in different periods. On the other hand, microstructure approaches to exchange rate determination demonstrate the importance of order flow to both explain and forecast exchange rates. Monthly data sets for order flow on the three currency pairs $/€, ¥/$ and SEK/€ along with their macro ‘fundamentals' are used to explore this puzzle. We find evidence supporting scapegoat effects that (i) the instability in the return-fundamentals relation is matched by a similar instability in the relation between order flow and fundamentals; and (ii) the predicted order flow from the time-varying relation with fundamentals (macro-induced order flow) has strong explanatory power for spot returns. We conclude that the consistent and more stable impact of order flow, in part, comes from the fact that it absorbs and acts as a sufficient statistic for scapegoat effects