Safe dollar assets, such as Treasury securities, carry significant convenience yields. Their suitability for liquidity management and collateralization means that they provide value over and above financial return. The dollar exchange rate clears the market for safe dollar-denominated assets. Hence, when the convenience value of such assets turns positive the dollar appreciates above its long-term equilibrium, similar to classical exchange rate overshooting. Changes in convenience yields are common responses to financial crises, monetary policy actions, and regulatory changes. A proxy for such fluctuations is the Treasury basis, the difference between an actual Treasury yield and the yield on a synthetic counterpart based on foreign-currency yields and FX hedges. There is empirical support for the link between the Treasury basis on the dollar exchange rate.

Krishnamurthy, Arvind and Hanno Lustig (2019), “Mind the Gap in Sovereign Debt Markets: The U.S. Treasury basis and the Dollar Risk Factor.”

The below are excerpts from the paper. Headings and text in brackets have been added.
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.
View a related previous post on liquidity yields and FX here. 

What is the Treasury basis?

“The U.S. Treasury basis measures the yield on an actual U.S. Treasury minus the yield on an equivalent synthetic U.S. Treasury constructed from a foreign bond with the same maturity…[as] the difference between the yield on a cash position in a U.S. Treasury bond and the yield on…a long position in a foreign government bond…hedging the currency risk.”

“Interest rate spreads with foreign countries provide an incomplete picture to gauge the impact of the stance of U.S. monetary policy on currency markets. The Treasury basis, since it measures the convenience yield on dollar safe assets, completes the picture.”

“The average U.S. Treasury basis has been consistently negative against G-10 currencies [because] the synthetic Treasury is not perceived to yield the same safety and liquidity services as the actual Treasury… Between 1997 and 2019, the average Treasury basis ranged from -23 bps at the 3-month horizon to -6.43 bps at the 10Y horizon… In the post-crisis sample, the term structure has tilted and become upward sloping, i.e., the Treasury bases are negative at the short end (-24 bps) and positive at the long end.”

“The U.S. balance sheet relative to the rest of the world is unconventional: the U.S. shorts domestic dollar-denominated safe assets to fund its risky investments abroad…Treasuries obviously account for a large share of these dollar-denominated safe assets. In June of 2018, foreigners held about $6.225 trillion in U.S. Treasuries. The total Treasury debt held by the public was $15.466 trillion. Foreign holdings of Treasuries currently account for 40% of the U.S. federal government debt. The fraction of Treasuries owned by foreign investors has roughly doubled in the past two decades.”

What is the USD asset convenience yield?

“When the U.S. issues dollar-denominated [debt securities] to foreign investors, the U.S. also exports the liquidity and safety services provided by its supply of dollar-denominated safe assets. Foreign investors derive a convenience yield, which reflects the value of these liquidity and safety services, on their holdings of dollar-denominated safe assets, lowering their required return.”

“The U.S. Treasury basis…is a measure of the convenience yield on safe dollar bonds. However, the Treasury basis measures only that part of the convenience yield that is due to the safety and liquidity of Treasuries because we are comparing cash U.S. Treasuries to synthetic (foreign) Treasuries. The second component of the convenience yield is the part that is due to the value of a safe position in dollars. According to our estimates, the entire convenience yields which comprise the combined dollar/Treasury safety effects are significantly larger (more than 5 times larger) than the Treasury basis itself. The dollar-specific convenience yield can be inferred from the response of the dollar exchange rate to an innovation in the Treasury basis.”

“The U.S. collects safe asset seignorage on its issuance of dollar bonds to foreign investors, as attested by the exceptionally low returns foreign investors earn on their net purchases of Treasuries. This has shaped the highly levered aggregate capital structure of the U.S. relative to the rest of the world.”

How are USD Treasury basis, convenience yield and exchange rate linked?

“The U.S. dollar exchange rate plays a key role in clearing the global market for dollar-denominated safe assets. When the marginal willingness of foreign investors to pay for dollar-denominated safe assets rises, the dollar appreciates to induce an expected depreciation and thus lower the returns expected by foreign investors on their holdings of dollar-denominated safe assets [a form of overshooting].”

“Shifts in the demand and supply of safe dollar assets are important drivers of variation in the dollar exchange rate, bond yields, and other global financial variables.”

Shocks to the demand and supply of dollar-denominated safe assets will alter the expected path of future convenience yields, the basis, and hence the dollar exchange rate. When the convenience yield increases and the U.S. basis widens, the dollar tends to appreciate against G-10 currencies.”

The Federal Reserve’s conventional and unconventional monetary policy actions directly impact the global supply of dollar-denominated safe assets and the dollar exchange rate. When the Fed tightens, the bond markets infer that a reduction in the supply of safe dollar assets is imminent. As a result of this supply shift, the marginal willingness of global investors to pay for the safety and liquidity of dollar-denominated assets – as measured by the convenience yield on these assets – increases, leading to an appreciation of the dollar in response to this increase in the convenience yield (even when controlling for interest rates). We refer to this as the convenience yield channel of monetary policy.”

“The equilibrium convenience yield on dollar-denominated safe assets (DDSA) depends on the marginal willingness to pay for the services of DDSA, and on the supply of these services, i.e. the stock of DDSA. As the price of these services increases, the quantity foreign investors demand increases. The supply of DDSA is upward sloping because other issuers (governments, banks and corporations) supply more DDSA as the price for these services increases.”

“Dollar liquidity is provided by safe dollar bonds that are issued not only by the U.S. government, but also by foreign governments, U.S. and foreign banks, as well as multinationals. The demand for dollar safe assets, and the convenience yield, drives funding and capital structure decisions inside and outside of the U.S. Outside of the U.S., debtors around the world, especially in emerging market countries, are short the dollar because they seek to benefit from the funding advantages of issuing dollar bonds. As a result, foreign borrowers, especially those not exporting and invoicing in dollars, may be subject to a currency mismatch.”

When there is a crisis in global financial markets, the convenience yield on dollar safe assets increases persistently, strengthening the dollar’s funding advantage, and incentivizing foreign issuers to tilt future issuance even more towards the dollar, thus sowing the seeds for the next crisis. We refer to this dynamic as the dollar cycle.”

“When the dollar exchange rate appreciates…the debt burden in local currency of these foreign borrowers increases. In countries that rely more heavily on dollar funding, we find that the local currency depreciates more against the U.S. dollar in response to an increase in the safe asset convenience yield, and the net effect of the convenience yield increases on the country’s external debt burden is larger.”

What is the empirical evidence?

Shifts in the demand and supply of safe dollar assets…[and] variation in the market’s assessment of current and future convenience yields… [are] major drivers of variation in the dollar exchange rate… Since the financial crisis, as the dominance of the dollar has increased, this convenience yield effect on the dollar exchange rate has strengthened even further. We find the basis of the Euro or Yen has a far more muted relation with FX markets.”

“[Our research] identifies changes in the U.S. Treasury basis as a key driver of exchange rate covariation not only among G-10 currencies, but also among emerging market currencies, even though we measure the Treasury basis only against G-10 currencies. The dollar exchange rate is a global risk factor, because it measures the scarcity of dollar safe assets. Carry trades which go long in high interest rate currencies and short low interest rate currencies will be exposed to this global dollar risk factor, even though they are nominally dollar-neutral.”

“The quantitatively significant estimates of the effects of the Treasury basis on the dollar exchange rate can inform our assessment of the total convenience yield that accrues to foreign investors from holdings of safe dollar assets…A wider and hence more negative basis corresponds to a larger convenience yield…The Treasury basis is strongly negatively correlated with the percentage rate of appreciation of the dollar. As predicted, an increase in the perceived convenience yield coincides with a strengthening of the US dollar against G10 currencies… These results are robust to controlling for average yield differences.”

“[The figure below] shows the loadings on the basis risk factor (i.e. the risk that the Treasury basis widens) for 5 portfolios of developed currencies: currencies are sorted each month by their interest rate differences into portfolios, with the first portfolio containing the lowest interest rate currencies. After the crisis, all of the loadings have increased in absolute value, and the carry pattern is even stronger than before the crisis.”

Monetary policy directly impacts the convenience yields (basis) and hence exchange rates, because the stance of monetary policy is perceived by market participants to affect the supply of dollar safe assets. When the Fed tightens by raising the Fed Funds Rate target, the future supply of dollar denominated safe assets is expected to shrink, resulting in a widening of the U.S. Treasury basis and an appreciation of the dollar, even after controlling for interest rate changes. We use FOMC-induced variation in the US Treasury basis around FOMC announcements to help us identify the causal effect of variation in the basis on the dollar exchange rate. Similarly, we also exploit variation in the basis around QE announcements which had large and varying effects on the basis, and on the dollar exchange rate. In both cases, we find that the widening of the basis induces a significant appreciation of the dollar.”

“In some events the basis widens and the dollar appreciates, while in others the basis contracts and the dollar depreciates. This effect is consistent with our characterization of quantitative easing actions as expanding or contracting DDSA depending on the type of action. We also see the strong relation between the movement in the Treasury basis induced by these supply changes and the movements in the dollar.”

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 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.