Driving FX markets - common risk factors?

What drives the FX markets? This is a critical but complex issue for any investor who needs to look at this asset class. The usually approach is to develop a model with a some key fundamental factors like rates, inflation, or money and then see what the reduced form empirical relationships show significant relationships. However, this problem can be looked at with a more primal lens through the use of principal components. Using this approach, it is possible to determine how many common factors may drive currencies.

Researchers have found that there are two principal components that can drive these markets. See "Common risk factors in currency markets"  by Lustig, Rousssanov and Verdelhan. The main first principal component can explain about 70% of the variation is related to risks versus the dollar. These are the usual risks investors often thing about with respect to currencies. What is more interesting the second principal component that seems to do a very good job of explaining the cross-sectional variation in currencies and explains about 12.5% of the variation.

This common factor  explaining excess return is sloped with respect to the forward discount or interest differential. Simply put, excess returns are associated with high foreign interest rates. This is the classic carry trade factor.  What is important with this factor is that it seems to be related to world risk and is counter-cyclical. It is like the risk premium found in stocks and bonds. When there is higher forward discounts, there will be higher excess returns from the high foreign rates, but this is associated with pricing of world risk. 

This story makes sense that carry will do poorly if there is a recession or if there is an increase in global volatility. You are not getting a truly unique return pattern but one that will be sensitive to the business cycle. Excess returns from currencies with high interest rates need to compensate for the risks associated with "bad times". Low rate currencies will be safe havens. This work does to mean avoid carry trades or currencies but it better explains that you are receiving excess returns for specific risks.