Foreign Safe Asset Demand and the Dollar Exchange Rate
93 Pages Posted: 21 Mar 2018
Date Written: March 15, 2018
We develop a theory that links the U.S. dollar's valuation in FX markets to
foreign investors' demand for U.S. safe assets. When the convenience yield
that foreign investors derive from holding U.S. safe assets increases, the U.S.
dollar immediately appreciates, thus lowering the foreign investors' expected
future return from owning U.S. safe assets. The foreign investors' convenience
yield can be inferred from the wedge between the yield on safe U.S.
Treasury bonds and currency-hedged foreign government
bonds, which we call the U.S. Treasury basis. Consistent with the theory, we
find that a widening
of the U.S. Treasury basis coincides with an immediate appreciation and a
subsequent depreciation of the U.S. dollar. Shocks to news about current and
future convenience yields accounts for 54.2% of the quarterly innovations in
the dollar. Our results lend empirical support to recent theories of exchange
determination which impute a special role to the U.S. as the world's provider of safe assets and to the dollar, the world's reserve currency.
Keywords: Covered Interest Rate Parity, Exchange Rates, Safe Asset Demand, Convenience Yields
JEL Classification: F31
Suggested Citation: Suggested Citation