An Unintended Consequence of Holding Dollar Assets

Abstract

We examine a novel mechanism whereby the global dominance of dollar assets can have a large, unexpected impact on foreign Treasury yields in crisis periods. Non-US institutions hold substantial dollar assets and hedge dollar exposures by selling dollars forward. In crisis periods, the dollar appreciates against other currencies. To meet margin calls on FX hedging positions, traditionally passive institutions sell domestic safe assets, contributing to yield spikes in domestic markets. We show that during the recent COVID crisis, UK institutions with substantial dollar holdings and FX hedging positions sold large amounts of gilts, which contributed to the observed gilt yield spike.

Keywords: Covid crisis, gilt yields, variation margin, FX derivatives, global reserve currency, currency hedging, dollar assets

JEL Classification: F31, G11, G12, G15, G22, G23