Dollar Safety and the Global Financial Cycle

Abstract

U.S. monetary policy shocks have an outsized impact on the world economy, a phenomenon that is described by Rey’s (2013) “global financial cycle”. In contrast, shocks in foreign countries have smaller impacts on the U.S. We build a model to rationalize these facts based on the special demand for dollar safe assets. In the model, dollar safe assets trade at a premium: that is, they offer especially low returns. Banks and firms that have the collateral to issue dollar safe assets can collect this premium. U.S. institutions do so against dollar collateral, while foreign institutions do so against foreign currency collateral, taking on exchange rate risk in the process. U.S. monetary shocks impact the supply of dollar safe assets, affecting dollar safe assets’ premium and the dollar's value. This impact transmits across the globe and generates a global risk factor. We present evidence from movements in the Treasury basis to support the mechanism underlying our theory.

Keywords: Covered interest rate parity, exchange rates, safe asset demand, convenience yields

JEL Classification: F31