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 rate 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.
and the 2019 AEA for their comments. We have read the Journal of Finance disclosure policy and have no con icts of interest to disclose. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.
The government budget constraint ties the market value of government debt to the expected present discounted value of fiscal surpluses. Bond investors fail to impose this no-arbitrage restriction in the U.S., resulting in a government debt valuation puzzle. Both cyclical and longrun dynamics of tax revenues and government spending make the surplus claim risky. In a realistic asset pricing model, this risk in surpluses creates a wedge of 2.5 times GDP between the value of debt and that of the surplus claim, and implies an expected return on the debt portfolio that far exceeds the observed yield on Treasuries.
We present theory showing that the spot dollar exchange rate reflects the value of all future convenience yields that foreign investors assign to US Treasuries. The convenience yield also creates wedge, the Treasury-based dollar basis, between the yield on foreign bonds and the currency-hedged yield on US Treasury bonds. We use the Treasury basis to measure the foreign convenience yield and show that an increase in the basis coincides with an appreciation of the dollar, consistent with the theory. The variation in the Treasury basis accounts for 25 percent of the quarterly variation in the dollar between 1988 and 2017.
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