AFlight to Quality A study of how uncertainty and recessions relate to currency valuations

Abstract

This empirical study analyzes the relationship between real currency returns and US Economic Policy Uncertainty (EPU) with a distinction between low/high-yielding currencies. By employing a DCC-GARCH model, the paper examines the dynamic correlation between the variables. Additionally, a VAR model is implemented to determine how the correlation is impacted by a US recession. The research is based on the gold price and a collection of 26 floating/free-floating currencies from 1999 to 2024. Key findings indicate that low-yielding (high-yielding) currencies exhibit a positive (negative) correlation with US EPU implying a "flight to quality" phenomenon during periods of heightened uncertainty. The results for the low-yielding currencies are similar to gold, implying that similar safe-haven characteristics are shared between them. Additionally, results from the VAR model indicate tendencies of a strengthened dynamic correlation during recessions. These results are nevertheless statistically insignificant for the majority of currencies examined and the lack of significance is attributed to the limited recessionary data used.