In a classical model, “exchange rates are determined by the demand or tastes for different countries’ assets and by the production of different countries’ goods,” says Zhengyang Jiang, an assistant professor of finance at Kellogg. In other words, it should all come down to supply and demand—or more precisely, the economic variables such as population size, employment, consumption, production, and GDP that are associated with supply and demand.
There’s only one problem: most of these variables don’t seem to explain shifts in exchange rates at all. It’s a quandary that economists call the “exchange rate disconnect puzzle.”
But new research by Jiang and his coauthors finds an economic variable that does seem to do a pretty good job of explaining how the U.S. dollar appreciates and depreciates against other currencies. It comes down to something a bit surprising: demand not for U.S. goods, but for U.S. dollar safe assets.
“The special demand for safe assets, and dollar safe assets in particular, is closely related to exchange rates,” says Jiang, who teamed up with Arvind Krishnamurthy and Hanno Lustig, both of Stanford, on the research.
More broadly, their research quantifies the “specialness” of the dollar—and explores its consequences for the global economy.
How the U.S. Dollar Is Special
To make sense of these findings, it’s important to understand that U.S. Treasuries are generally seen as the safest investment in the world. As such, they are prized by investors—meaning the U.S. can pay lower interest rates on its bonds.
“When the U.S government raises funds from foreign investors, it’s funding rate is usually from 0.2 percent to 1 percent lower than comparable funding rates from similar foreign governments, once we account for their exchange-rate differences,” says Jiang.
That difference—essentially the yield that investors are willing to forgo when they purchase U.S. Treasuries—is known as a “convenience yield.” You can think of it as the market value of the convenience and peace of mind that comes with investing in U.S. dollars as opposed to, say, Euros or other relatively safe assets.
“The idea is that the dollar has some quality: being the most safe asset in the world, being liquid so you can easily trade with people,” says Jiang.
This yield changes over time, he explains. During periods of instability, it increases, as investors flee to the safety of U.S. Treasury bonds; during more stable periods, it shrinks.
But critically, the convenience yield can also differ across investors, such as when foreign investors value the convenience and safety of U.S. Treasuries differently than U.S. investors. And when this occurs, something interesting happens.
“Let’s suppose foreigners want the U.S. safe assets more badly than the U.S. investors,” says Jiang. “They are willing to accept a lower return on these special assets than U.S. investors.”
But, of course, a given Treasury bond will have only a single interest rate. So the market responds to these differences in demand in another way: by shifting the currency exchange rates. Specifically, the U.S. dollar will appreciate against foreign currencies. (While exchange rates with an individual currency might move in an idiosyncratic way, foreign currencies overwhelmingly tend to move in tandem, so it becomes useful to speak of the average movement of the dollar.)
It’s this mechanism that allows foreign investors to receive a lower return, in their own currencies, than American investors. “Whenever there is a higher foreign demand for U.S. assets,” says Jiang, “then the dollar is going to be stronger and provide a lower return as a consequence.”
In fact, the new research finds that a large fraction of the variation in dollar exchange rates over time can be explained by the ever-fluctuating value that foreign investors place in holding a safe asset.
“This is one way to explain why there is a disconnect between the exchange rates and the fundamental variables that we thought should be able to explain exchange rates,” says Jiang.
Why So Special?
To make this determination, the researchers analyzed both exchange-rate data and the demand from foreign investors for U.S. safe assets. The former data were easy to come by, but the latter required researchers to calculate what they call a “synthetic” dollar rate—basically the interest rate for a comparable asset, such as a Japanese government bond, after taking into account the need to enter a currency-swap position, which would protect investors against exchange-rate movements between the U.S. dollar and the yen.
“By comparing these two interest rates—the Treasury rate and a synthetic rate—we’re able to observe a spread that reflects the specialness of the U.S. Treasury,” says Jiang. “We should expect their rates to be similar because they are pretty much the same thing. And to our surprise, they are very different.”
In a crisis, he explains, the spread increases, and in less turbulent times, it drops towards zero.
The researchers also built a model that allowed them to determine how much of the Treasury bonds’ “specialness” could be attributed to the fact that they were issued by the Treasury specifically. In other words, are only Treasury bonds special, or are all safe assets issued in U.S. dollars prized by investors?
“Our findings are that about 10 percent of the overall dollar specialness manifests itself as the Treasury specialness. And about 90 percent is attributable to the dollar itself being special,” says Jiang.
This is a surprising finding, he notes. And it suggests that it is beneficial for even nongovernment entities to issue debt in U.S. dollars—particularly private-sector companies with strong credit ratings, whose debt would qualify as safe assets.
“These companies could also issue dollar debt at a lower financing rate than comparable foreign interest rates after we account for their currency differences,” says Jiang, who points out that even foreign companies could benefit if they issued their debt in U.S. dollars.
“It seems the dollar is really special, and being able to issue safe assets in dollars really gives you an edge.”
A Huge Ripple Effect
The research provides a richer understanding of when and how the exchange rate moves: when the dollar appreciates, it’s likely that demand among foreign investors for U.S. safe assets has increased relative to domestic investors.
But it also suggests a novel way for U.S. policies to have global reach.
“The special demand for U.S. safe assets opens up a whole new set of mechanisms for U.S. monetary policy to affect the global economy,” says Jiang. “U.S. monetary shocks can affect the safe-asset premium, which in turn trickles down through the global economy.”
In Jiang’s view, the Fed should carefully consider the potential ripple effects of policies that promote domestic interests. Take quantitative easing, in which the Fed buys up a large amount of Treasury assets in an effort to provide liquidity to the U.S. financial system.
“What this means for foreigners is, first, scarcity in the supply of reserve assets and, second, an appreciation of the dollar through the mechanism we discussed,” says Jiang.
But because many countries borrow in dollars while their cash flows are in foreign currencies, the U.S. dollar’s appreciation can trigger a wave of defaults or financial stress elsewhere in the world.
“In this way, depending on how quantitative easing affects the supply of dollar safe assets, it can lead to a bit more financial turmoil in foreign countries,” says Jiang. That is, given the interconnectedness of the global economy, a policy intended to stabilize the U.S. economy could be at least partly undercutting its own goals.
However, theoretically, the Fed could also harness this mechanism to stabilize foreign financial systems. In response to a financial crisis in Europe, for instance, the U.S. could increase its supply of reserve assets and provide more liquidity to the market.
“How should we think about these spillover effects?” he asks. “What is our duty or responsibility [in terms of channeling] these novel forces that we are only starting to understand?”
