Foreign Safe Asset Demand and the Dollar Exchange Rate

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 yields 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. Our results lend empirical support to models 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.