Unemployment fluctuations and currency returns in the United Kingdom: Evidence from over one and a half century of data

Highlights

• We analyze the time-varying causal links between the British pound and unemployment.

• We utilise data from 1856 to consider the impact of different exchange rate regimes.

• Wavelet decompositions are used to measure excess returns for the British pound.

• A significant causal link is found between the variables, which increases during crises.

• The findings indicate significant spillovers in both directions over most of the sample.

Abstract

This paper provides a long-term perspective on the causal linkages between currency dynamics and macroeconomic conditions. We utilise a long-span data set for the United Kingdom that extends back to 1856, and a time-varying causality testing methodology that accounts for nonlinearity and structural breaks. Using unemployment fluctuations as a proxy for macroeconomic conditions and wavelet decompositions to obtain the fundamental factor that drives excess returns for the British pound, time-varying causality tests based on alternative model specifications yield significant evidence of causal linkages and information spillovers across labour and currency markets over the majority of the sample. Causal effects seem to strengthen during the Great Depression and later following the collapse of the Bretton Woods system, highlighting the role of economic crises in the predictive linkages between the two markets. While the predictive role of currency market dynamics over unemployment fluctuations reflects the effect of exchange rate volatility on corporate investment decisions, which in turn drives subsequent labour market dynamics, we argue that causality in the direction of exchange rates from unemployment possibly reflects signals regarding monetary policy actions, which in turn spill over to financial markets. Overall, the findings indicate significant information spillovers across labour and currency markets in both directions with significant policy making implications.

Introduction

In an informationally efficient setting, financial market fluctuations reflect changes in economic fundamentals and risk preferences. In the case of currencies, the present value models suggest that currency values should reflect investors’ expectations about the current and future macroeconomic conditions (Frenkel and Mussa, 1985, Cochrane, 2005). However, a long-standing puzzle exists regarding the linkage between exchange rate movements and macroeconomic fundamentals. Pioneered by the seminal work of Meese and Rogoff (1983) who find that macro-economic fundamentals fail in predicting exchange rate movements, the so-called ‘disconnect puzzle’ presents a challenge to the present value models in their ability to explain short-run exchange rate fluctuations.¹ In addition, studies including Berkowitz and Giorgianni (2001) and Faust et al. (2003) also cast doubt over the ability of macroeconomic fundamentals to predict fluctuations in exchange rates over the long-run. However, in contrast with these findings, Engel and West (2005) observe that the current economic conditions, as well as expected macroeconomic fundamentals, influence exchange rates. This finding is largely supported by the results in Baxter (1994), Engel et al. (2008), Sarno and Schmeling (2014), and Yin and Li (2014), while several other studies have also shown that macroeconomic factors may influence the future behaviour of exchange rates over longer horizons (e.g., Mark, 1995, Abhyankar et al., 2005.² Given the mixed findings in the literature and the limitation in the sample periods that largely correspond to the floating exchange-rate regime settings, this study presents a long term perspective to the linkage between exchange rates and unemployment fluctuations by utilising a data set that extends back to 1856 to examine the dynamic causal interactions between currency excess returns and unemployment growth for the United Kingdom (UK).

Although unemployment is an important indicator of economic activity as businesses and policymakers keep a close eye on the changes in the unemployment rate, the role of unemployment fluctuations has received relatively less attention in the international finance literature.³ In a recent study, however, Nucera (2017) establishes a predictive relationship between unemployment growth rate and currency returns such that currencies of countries with lower (higher) growth in the unemployment rate appreciate (depreciate) in subsequent periods, suggesting the presence of an idiosyncratic unemployment risk factor that is driving currency market performance.⁴ In this paper we seek to explore the time-varying nature of this relationship in greater detail over an extended period of time, where we make use of long-span data for the UK and various forms of wavelet decompositions that are used to generate a measure for excess returns. This implies that contrary to most of the previous studies in the literature, we are not constrained to a relatively limited sample length by the use of futures market data, which starts in 1983. The use of long-span data in our context provides an interesting perspective to the currency-macroeconomy relationship as we are able to consider how the use of different exchange rate mechanisms may have influenced this relationship. Accordingly, the analysis of the long span data provides a more comprehensive insight as the UK has experienced a rather volatile unemployment pattern over the last century with notable highs in the mid-1920s and 1930s in double-digits and episodes of rising and declining unemployment rates (see Fig. 1). These patterns are accompanied with notable events that influenced economic activity, which start with the first Commercial Crisis in 1857 and include the Great Depression of 1929, the two world wars, the nationalisation of the coal industry in 1947, post-war immigration from Commonwealth in 1948, the borrowing from the International Monetary Fund in 1976 due to the sterling crisis, the economic recession of 1982, financial deregulation in the mid-1980s and the great financial crisis of 2007–2008.

Previous studies that have attempted to explore the dynamic causal relationships between currency returns and other macro-economic variables have largely focused on the relationship between the exchange rate and a countries’ external imbalances (Della Corte et al., 2012, Della Corte et al., 2016), sovereign risk (Della Corte et al., 2014), and global macroeconomic uncertainty shocks (Berg and Mark, 2018, Della Corte and Krecetovs, 2016). In addition, several studies have also investigated the significance of exchange rate volatility on the level of unemployment, after taking into consideration the characteristics of the labour market. For instance, Andersen and Sørensen (1988) address the importance of exchange rate variability for wage formation in open economies with strong trade unions. They argue that in the case of economies with stronger trade unions, increased exchange rate variability may increase real- and product wages and lower employment. Similarly, Belke and Gros (2001) show that an increase in exchange rate variability can induce firms to postpone their investments (which is associated with lower employment) as it raises uncertainty of future earnings. Similar findings are provided in Belke and Kaas (2004), where it is suggested that higher exchange rate volatility will provoke firms in countries with significant labour market rigidities and wage bargaining power to delay job creation.⁵ Similarly, Stirböck and Buscher (2000) and Feldman (2011) also find that higher exchange rate volatility increases the unemployment rate. Hence, although the existing literature provides a number of economic arguments that can be used to establish a causal relationship between exchange rate volatility and unemployment dynamics, it has not considered how this relationship has evolved over an extended period of time.

This study contributes to this literature in multiple aspects. First, we propose new time-varying causality tests to investigate the predictive relationship between unemployment fluctuations and currency excess returns. As is noted in Cogley and Sargent (2005) and Primiceri (2005), although the widely used time-varying parameter vector autoregressive (VAR) models can detect time-varying causal relationships, these models are not able to show the overall causal effects of the individual variables. In our case, we not only assess time-varying causal relationships, but also estimate their overall (bi-directional) causal effects, which makes it applicable to the time-varying market integration and financial contagion context. Second, ours is the first study that assesses the predictive causation between the unemployment fluctuations in the UK and currency excess returns using long range data extending back to 1856. Finally, our study also presents a technical novelty via the use of the wavelet decomposition approach in order to generate an underlying fundamental value for the exchange rate which is then used to compute excess currency returns as futures data (traditionally used to compute excess currency returns) is only available after the mid-1980s, thus largely restricting the sample period.

Our findings suggest that there are significant information spillovers in both directions over the majority of the sample, suggesting that currency excess returns and unemployment dynamics capture valuable predictive information over the subsequent state of the other variable. This result is in stark contrast to the standard linear Granger causality test which finds no evidence of bi-directional causality, possibly due to the presence of structural breaks and nonlinearity in the relationship between the two variables and hence indicative of misspecification in the linear model. We also present evidence of instantaneous causation, particularly when we consider the transmission from the more readily available exchange rate data. While the predictive role of currency market dynamics over unemployment fluctuations reflects the effect of exchange rate volatility on corporate investment decisions, which in turn, drives subsequent labour market dynamics (e.g., Belke and Gros, 2001, Belke and Kaas, 2004, Feldman, 2011; among others), we argue that causality in the direction of exchange rates from unemployment possibly reflects the signals regarding monetary policy actions, which in turn, spills over to financial markets. Overall, the findings indicate significant information spillovers across the labour and currency markets in both directions with signification implications for policy makers.

The rest of the paper is structured as follows. Section 2 provides details relating to the construction of the test statistics and Section 3 describes the essential characteristics of the data. Section 4 reports the empirical findings for time-varying causality and Section 5 concludes.