Exchange Rates and Unobservable Fundamentals: A New Approach to Out-of-Sample Forecasting

Traditional exchange rate models are based on differences in macroeconomic fundamentals. However, despite being well grounded in economic theory they have a rather poor out-of sample forecasting record. This empirical failure may be a result of the overly restrictive choice of macroeconomic fundamentals. We suggest using the empirical sovereign yield spread level and slope as proxies of the market's expectations for current and future fundamentals and find promising results when we investigate the forecasting accuracy of these variables. Using the yield spread level and slope as a set of unobservable fundamentals, our model outperforms traditional exchange rate models for most considered currencies and horizons. It is also superior to a random walk in terms of direction of change forecasts and profitability.