Liquidity yields are convenience yields of financial securities that typically arise from high liquidity, suitability as collateral or preferred regulatory status. New research argues that relative changes in liquidity yields on government bonds across countries have a significant impact on exchange rate dynamics. Theoretically, an unexpected increase in the liquidity yield on government bonds in country A relative to country B triggers an appreciation of the currency of A versus B in very much the same way in which an unexpected rise in the short-term interest rate differential would. Empirically, there is evidence of a significant and consistent impact of relative liquidity yield changes on exchange rate dynamics across the G10.

Engel, Charles and Steve Pak Yeung Wu (2018), “Liquidity and Exchange Rates: An Empirical Investigation”, NBER Working Paper No. 25397, December 2018

The post ties in with SRSV’s summary lecture on macro trends, particularly the section on how to use information implicit in financial markets data.
The below are excerpts from the paper. Emphasis and cursive text have been added.

Understanding liquidity yields

“The word ‘liquidity’ appears in different economic contexts with different meanings. Here, it refers to a non-observable non-pecuniary return that investors enjoy when holding the asset…The liquidity return on government bonds…[is] the non-monetary return that government short-term bonds provide because of their safety, the ease with which they can be sold, and their value as collateral, which is sometimes referred to as the ‘convenience yield’…Measures of the liquidity yield…take the difference between a riskless market rate and the government bond rate [potentially corrected] for frictions in…markets and for sovereign default risk.

“Investors are willing to hold the government bond instead of the [money] market instrument, because the Treasury bond is more easily sold on markets, or is more readily accepted as collateral. It may be the case that some agents in the economy have no need for liquidity, in which case their holdings of the government bonds would be zero. But [most] private agents cannot short government bonds.”

“The monetary policy instrument is the interest rate ex-convenience yield. Thus, the interest rate responds endogenously to inflation in a way that the convenience yield does not.”

On the impact of convenience yields on government bond yields view post here.
On the disparities between various short-term yields view post here.

Why liquidity yields affect exchange rates

“The intuition for why the government bond convenience yield influences the exchange rate is straightforward. The liquidity that these bonds provide is attractive to investors and influences their investment decisions as if the bonds were paying an unobserved convenience dividend. The government bonds can pay a lower monetary return than other bonds with similar risk characteristics, and still be desirable. An increase in the liquidity yield, as measured by the difference between the private bond return and government bond return, will ceteris paribus lead to a currency appreciation much in the same way that an increase in the interest rate would affect the currency value. “

“The expected excess return on foreign one-period government bonds relative to home bonds is determined by the liquidity yield of home government bonds relative to foreign bonds. When the home bonds are more liquid, the foreign bonds must pay a higher expected monetary return…
We posit that the ex-ante excess return on short-term Treasury bonds in one country relative to another is attributable to an unobserved liquidity premium [approximated as] the difference in…the return on a short-term, one-period market instrument…[and] the one-period interest rate in the… government bonds…[One can also] adjust the returns for default risk using credit default swap (CDS) data. “

“The uncovered interest parity deviation is indeed observable and can be well-measured by the relative liquidity yield on government bonds…When the infinite sum of the expected current and future home interest rates rises relative to the expected infinite sum of expected current and future foreign interest rate, the home currency appreciates…A higher relative liquidity return on home government bonds also leads to an appreciation of the domestic currency. “

“Positive relationship between the relative liquidity return and the interest differential arises…when the monetary authority tightens monetary policy by reducing the supply of money and raising interest rates, liquid assets that can substitute for money become more valued for their liquidity services and so pay a higher liquidity return.”

Empirical evidence

“Our study uses monthly data from January 1999 to December 2017…We find impressive evidence that changes in the liquidity yield are significant in explaining exchange rate changes for all of the G10 countries

  • Treasury liquidity at the individual country level plays an important role in exchange rate determination. This contrasts the belief that there is a special role of the USD or the U.S. Treasury bond. We find that individual country treasury liquidity other than the U.S. is also important in understanding exchange rate fluctuations…
  • We investigate whether the relationship between treasury liquidity and exchange rates are driven by the Global Financial Crisis or the post-crisis period. …We see that the contemporaneous relationship between the change of the liquidity measure and the change of exchange rates holds in both time periods.”

“Our empirical specification for the depreciation of the exchange rate includes, first, an error correction term as the nominal exchange rate adjusts to disequilibrium in the real exchange rate. Second, the change in the interest differential affects the exchange rate as in standard New Keynesian models. Third, the change in the relative liquidity return on government bonds plays a role in influencing the exchange rate. Lagged levels of the relative interest differentials and liquidity returns capture the dynamic adjustment.”

“We measure the [liquidity yield] as the log of the FX forward rate and the log of the spot exchange rate plus the difference between the foreign and the home market instrument rate [which translates effectively a measure of the ‘cross-currency basis’].
Note that this approximation is not always precise, as there are factors other than liquidity or convenience yields that affect the cross-currency basis, such as interbank credit restrictions and regulatory constraints [view post here].”

Relevance of other fundamental exchange rate factors

“Using guidance from a standard New Keynesian model but augmented with a role for liquidity returns on government bonds, we find that the ‘standard’ determinants of exchange rate movements are statistically and quantitatively important after controlling for the liquidity yields. In particular, interest rate differentials and a lagged adjustment term for the real exchange rate are also important determinants of exchange rate movements.”

“Our empirical findings are good news for macroeconomic models of exchange rates. The government liquidity yield is the ‘missing link’ in exchange rate determination. Not only do we find that liquidity yields are a significant determinant of exchange rate movements for all of the largest countries, but we also find that with these included, traditional determinants of exchange rate movements are also important. Our simple regressions have high R-squared values, so can account for a large fraction of exchange rate movements. In short, exchange rates are not so disconnected after all.”

“Our empirical work finds strong evidence for the role of government liquidity yields, interest rates and adjustment toward purchasing power parity for ten different currencies.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.