Bond Convenience Yields and Exchange Rate Dynamics

Abstract

I propose a new explanation for the failure of Uncovered Interest Parity (UIP) that can rationalize not only the classic UIP puzzle, but also the recent evidence that the puzzle reverses direction at longer horizons. In the model, excess currency returns are driven by endogenous fluctuations in bond convenience yields (i.e. liquidity value) -- a fall in the home convenience yield leads to both a higher domestic interest rate and higher home currency returns, as investors require higher compensation for holding home bonds. The dynamics of the equilibrium convenience yields depend on government debt dynamics, and as a result the reversal in UIP violations is driven by the interaction between monetary and fiscal policy. I empirically investigate both of these key implications of the mechanism, and find that government debt and monetary policy are indeed important determinants of excess currency returns.