Investor sentiment in the US-dollar: Longer-term, non-linear orientation on PPP

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may Abstract:How is it possible that exchange rates move in the long run towards fundamentals, while professionals form consistently irrational exchange rate expectations? We look at this puzzle from a different perspective by analyzing investor sentiment in the US-dollar market. First, long-horizon regressions show that investor sentiment is connected with exchange rate returns at longer horizons, i.e. more than two years. Second, sentiment is cointegrated with fundamentals, whereas third, this relation becomes stronger, the larger exchange rate's misalignment from long-run PPP. In sum, investor sentiment's behavior in the US-dollar market closely matches with established facts of empirical exchange rate research. JEL classification: F31, G14Keywords: Exchange rates, investor sentiment, long-horizon regression, threshold VECM # Corresponding author. IntroductionForeign exchange markets, such as the US-dollar/Euro market, seem to be characterized by a separation along the time horizon (see Frankel and Rose, 1995, p.1718). At shorter horizons, i.e. up to one or two years, there reigns the "exchange rate disconnect puzzle" (see Obstfeld and Rogoff, 2000).At longer horizons, however, exchange rates appear linked with economic fundamentals (see e.g. Sarno and Taylor, 2002). Unfortunately, this longer-term tendency of exchange rates towards equilibrium values-revealed in empirical exchange rate research-has never been reconciled with actual professionals' expectations. On the contrary, evidence shows that professionals' exchange rate expectations are consistently irrational. 1 This leaves us with a puzzle: why are exchange rates in the long run in line with fundamentals, whereas professional forecasts underlie considerable "expectational errors" (Frankel and Froot, 1987, p.150)? Our paper contributes to this question from a different perspective, first by analyzing the effective time horizon, to what investor sentiment is connected with subsequent exchange rate returns, and further, by distinguishing between sentiment's short-and long-run determinants. In sum, we find investor sentiment in exchange rates to be longerterm oriented than the predefined forecast horizon states, to be aligned with exchange rate fundamentals and to depend nonlinear on the actual exchange rate deviation from long-run purchasing power parity (PPP).Researchers have always been unsatisfied with the consistent finding of "poor" exchange rate expectat...

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