The strategy involves USD currency pairs, using a Taylor rule signal incorporating inflation forecasts and output gaps. Currencies are sorted into quintiles and positions are taken based on the policy signal.
ASSET CLASS: CFDs, futures | REGION: Global | FREQUENCY:
Monthly | MARKET: currencies | KEYWORD: Taylor
I. STRATEGY IN A NUTSHELL
The strategy targets USD currency pairs across 15 countries, including Australia, Canada, Japan, and the Eurozone. A Taylor rule signal is computed using inflation forecasts, inflation targets, output gaps, and the actual interest rate, with constants β = 1.5, γ = 0.5, and λ. The Hodrick-Prescott filter is used to estimate output gaps. Currencies are ranked into quintiles based on the previous month’s policy signal, with long positions in the top quintile and short positions in the bottom quintile. The portfolio is rebalanced monthly.
II. ECONOMIC RATIONALE
The strategy exploits deviations of inflation from central bank targets, which influence interest rate adjustments via the Taylor rule. Higher projected rates attract capital, leading to currency appreciation. By forecasting relative interest rate differentials, the strategy predicts currency movements independently of traditional carry, momentum, or value strategies. Empirical evidence shows the strategy remains significant after transaction costs, highlighting the predictive power of Taylor rule-based signals in FX markets.
III. SOURCE PAPER
Forward-Looking Policy Rules and Currency Premia [Click to Open PDF]
Ilias Filippou, Florida State University; Mark Peter Taylor, Washington University in St. Louis – John M. Olin Business School, Centre for Economic Policy Research (CEPR), Brookings Institution
<Abstract>
We evaluate the cross-sectional predictive ability of a forward-looking monetary policy reaction function, or Taylor rule, in both statistical and economic terms. We find that investors require a premium for holding currency portfolios with high implied interest rates while currency portfolios with low implied rates offer negative currency excess returns. Our forward- looking Taylor rule signals are orthogonal to current nominal interest rates and disconnected from carry trade portfolios and other currency investment strategies. The profitability of the Taylor rule portfolio spread is mainly driven by inflation forecasts rather than the output gap and is robust to data snooping and a wide range of robustness checks.
IV. BACKTEST PERFORMANCE
| Annualised Return | 6.16% |
| Volatility | 7.61% |
| Beta | N/A |
| Sharpe Ratio | 0.81 |
| Sortino Ratio | N/A |
| Maximum Drawdown | N/A |
| Win Rate | N/A |
