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Cambridge-INET Institute   COVID-19 Economic Research


At times of global economic crises, the dollar tends to appreciate sharply, especially against emerging market (EM) currencies, dollar liquidity becomes scarce and capital flows out of weak regions in the world, into the US.

In work conducted in Cambridge-INET (Corsetti and Marin 2020 and Lloyd and Marin 2020), we have unveiled a striking regularity in bond and exchange (FX) markets around economic "disasters", as defined by Barro (2006). These are crises that result in a significant fall in economic activity and consumption, accompanied by large swings in exchange rates (see Farhi and Gabaix (2016)). We show that disasters are always preceded by an inversion of the US yield curve. Consistent with theory, the yield curve inverts because investors anticipate the "crisis" ahead and thus require relatively high short-term yields. Differences in investors perception of country risk generates an appreciation of relatively risky currencies— until the disaster occurs. At that point, the dollar appreciates sharply and the gates, so to speak, open: EMs suffer strong capital flight.1.

The same pattern is apparent in the COVID-19 crisis, as shown in the figure below. Figure 1 plots the evolution of key exchange rates against the dollar, indexed relative to 25th February 2020, when the US yield curve inverted (measured using the difference between 10 and 1-year US zero-coupon government bond yields). For a couple of weeks after the inversion, the US dollar lost value against the euro and the Japanese yen—while sterling remained broadly stable—and EM currencies depreciated somewhat. After that, from around the second week of March, the dollar strengthened markedly against all currencies to 19th March, when the Federal Reserve announced the establishment of temporary swap lines with a range of central banks—in addition to the extensions to its pre-existing swap line arrangements announced on 15th March.

In Lloyd and Marin (2020) we study exchange rate dynamics around disasters, for a panel of advanced countries since 1980 while in Corsetti and Marin (2020) we focus on bond and exchange rate markets for the US and UK for a long sample starting in the 1920s. Relative to previous crises, what is unprecedented is the speed of this sequence (it is fast, weeks instead of months) and the magnitude of the capital outflows from EMs (at furious rates, by all standards). In 2007-2008, the dollar appreciation materialised after six months. In the COVID-19 crisis, the dollar started to appreciate within two weeks of the initial yield curve inversion. Nonetheless, the exchange rate movement seen so far are smaller than those during the GFC.

Figure 1: COVID FX: Exchange Rate Dynamics around 25th February 2020 US Yield Curve Inversion

Note: Vertical solid black line denotes date of the US yield curve inversion, on 25th February 2020, where yield curve slope defined as the 10 minus 1-year yield zero-coupon yield. Exchange rates normalised relative to this date. Vertical dashed grey lines denote dates of Federal Reserve announcements to (a) extend the maturity of its existing swap line agreements with the Bank of Canada, Bank of England, Bank of Japan, ECB and SNB on 15th March 2020 and (b) establish temporary swap line arrangements with central banks in Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore and Sweden on 19th March 2020. USDEM7 a PPP-weighted average of 7 EM currencies: Brazil, India, Indonesia, Mexico, Russia, South Africa, Turkey. Dates: 3rd February 2020 to 30th March 2020. Data Source: Datastream.

We articulate our analysis in a VoxEU article published on April 3 2020. In this follow up we add a few key considerations. Some of the reasons the COVID-19 crisis is different are now understood. By the very nature of this crisis, markets are disrupted like never before in recent history as factories and retailers are forced to shut for a yet to be determined horizon—finnancial markets reflect this. Health risks have virtually zeroed the demand for a wide variety of goods and services: no income support will be able to jump start these markets for many months (years) ahead. Immense fiscal stimulus across advanced economies has been deployed to attempt to sustain income vis-à-vis crumbling demand and rising unemployment, flooding markets with government debt and monetary assets.

On the other hand, emerging economies, many of which have large sectors of their economies dollarised, cannot cope with the combined effect of the pandemia, a collapse in commodity prices worsening their terms of trade, plummeting export markets and, above all, massive capital out flows (see Figure 2). According to the IMF, nearly 85 countries have requested help by the end of March. Debt relief is now considered a relevant option, according to the standard used in response to natural disasters.

Figure 2: COVID CF: Capital Flows Dynamics

Source: Institute of International Finance "IIF Capital Flows Tracker: The COVID-19 Cliff", by Jonathan Fortun and Benjamin Hilgenstock.

What is very relevant for FX markets is that the Federal Reserve promptly re-established or activated dollar swap lines with foreign monetary authorities, with a commitment, so far, to massive financing. This has alleviated funding pressures and (arguably) tempered dollar movements—the effect can be detected in the Figure 1. But, looking forward, the question is whether countries that have traditionally played the role of financial safe havens will remain better equipped than other countries to deal with the crisis. This uncertainty may further feed disruptive volatility of capital flows and exchange rates in the near future.

As we have also stressed in the VoxEu column, the crisis is unfolding very fast and its magnitude is very large. Given the damage already done, there are few indications that the recovery will be quick, even if epidemiological breakthroughs will be able to eliminate the worse scenarios ahead.


Barro, R (2006), "Rare Disasters and Asset Markets in the Twentieth Century", The Quarterly Journal of Economics 121(3): 823-866.
Corsetti, G and E A Marin (2020), "A Century of Arbitrage and Disaster Risk Pricing in the Foreign Exchange Market", CEPR Discussion Paper, No. 14497.
Farhi, E and X Gabaix (2016), "Rare Disasters and Exchange Rates", The Quarterly Journal of Economics 131(1): 1-52.
Lloyd, S P and E A Marin (2019), "Exchange Rate Risk and Business Cycles", Cambridge Working Papers in Economics, No. 1996.


1While all the disaster in our sample are preceded by a yield curve inversion, as is well known, not all inversions are followed by a disaster. Our reasoning does not apply when inversions are driven by monetary policy


Professor Giancarlo Corsetti

About the authors
Professor Giancarlo Corsetti is Professor of Macroeconomics at the Faculty of Economics, University of Cambridge. His research expertise is International Economics and Open Economy Macroeconomics.

Emile Marin is a PhD student at the Faculty of Economics, University of Cambridge. His research interests are International Economics, Financial Economics and Optimal Policy.