Forecasting Exchange Rate Fundamentals with Order Flow

We study the macroeconomic information conveyed by transaction flows in the foreign exchange market. We present a new genre of model for the concurrent empirical link between spot prices and transaction flows that produces two new implications for forecasting: (i) transaction flows should have incremental forecasting power for future fundamentals relative to current spot prices and fundamentals, and (ii) transaction flows should have forecasting power for future excess returns if the information conveyed affects the risk premium. Both predictions are borne out empirically. Transaction flows in the EUR/USD market forecast GDP growth, money growth, and inflation. They also forecast future exchange rate returns, and this occurs via the information that flows carry concerning the future of the macro variables that drive the risk premium.

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