An Unintended Consequence of Holding Dollar Assets

Abstract

We study investor trading behaviour and yield patterns in the UK government bond market during the recent Covid crisis. We show that the yield spike in mid-March 2020 was accompanied by heavy selling of gilts by UK-based insurance companies and pension funds (ICPFs), which we argue was an indirect result of the US dollar’s global prominence. Non-US institutions invest a large portion of their capital in dollar assets and hedge their dollar exposures by selling dollars forward through FX derivatives. In crisis periods, dollars appreciate against other currencies. To meet margin calls on these short-dollar FX positions, non-US institutions sell their domestic safe assets, thereby contributing to the yield spikes in domestic markets.

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

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