Exchange rate spillover, carry trades, and the COVID-19 pandemic

Although it is widely accepted that exchange rates are connected, what drives these connections remains an unsettled question. We examine the interconnections and spillovers of G10 currencies over the period from January 1, 2018 to June 17, 2021. We find that the Euro and Australian dollar serve as risk transmitters whereas the Japanese yen operates as a risk recipient. During the COVID-19 pandemic period, countries with higher infection cases experience currency depreciation and transmit more currency risk to others. In response to this crisis, the Fed adopted the large-scale asset purchase program that weakened the USD and increased the demand for high-yield currencies through the portfolio rebalancing channel. The appreciation of high-yield currencies further attracts carry trades and enhances their risk transmission to low-yield currencies. Furthermore, we provide evidence to show that the COVID-19 infection cases, the Fed's policy, and carry trades are crucial determinants of exchange rate spillovers.