Exchange rates and macroeconomic fundamentals: Evidence of instabilities from time-varying factor loadings

We examine the relationship between exchange rates and macroeconomic fundamentals using a two-step maximum likelihood estimator through which we compute time-varying factor loadings. Factors are obtained as principal components, extracted from vintage macro-datasets that combine FRED-MD and OECD databases. Using 14 currencies over 1990-2021, we show that the loadings on the factors vary considerably over time and increase the percentage of explained variation in exchange rates by an order of magnitude. Time-varying loadings improve the overall predictive ability of the model, especially during crises, and lead to better forecasts of sign changes in exchange rates.