Foreign Safe Asset Demand and the Dollar Exchange Rate

The convenience yield that foreign investors derive from holding U.S. Treasurys causes a failure of Covered Interest Rate Parity by driving a wedge between the yield on the foreign bonds and the currency-hedged yield on the U.S. Treasury bonds. Even before the 2007-2009 financial crisis, the Treasury-based dollar basis is negative and occasionally large. We use the Treasury basis as a measure of the foreign convenience yield. Consistent with the theory, an increase in the convenience yield that foreign investors impute to U.S. Treasurys coincides with an immediate appreciation of the dollar, but predicts future depreciation of the dollar. The Treasury basis variation accounts for up to 25% of the quarterly variation in the dollar between 1988 and 2017.