How do changes in US government bond yields impact the USD exchange rate?

Question

I would like to understand how changes in US government yields impact the USD exchange against other major currencies, eg. the Canadian dollar or the yen.

• My question assumes that the bond yields impact exchange rate, and not the other way around. But I may be mistaken.
• I know that purchasing a US government bonds are sold in USD, therefore anyone buying US government bonds needs to buy USD.

Answer 1

Although there is seems to be some research on this topic, I doubt there is much (one directional) influence.

• For example, Japan's holdings of US government debt (bills, bonds, and notes) declined significantly in the last year, according to the FED broker and custodian data
• You may think it is because the value of treasury simply declined so much, but according to a Bloomberg article, investors in Japan were net sellers of US government securities for nine months through July.
• Even more importantly, interest rate changes are usually a result of monetary policy (government debt just follows the FED Funds rate). Insofar, the question of whether US interest rates (as opposed to US government bond yields) affect the exchange rate may be more relevant. Maybe long-term government bonds are less directly influenced by monetary policy, but a large junk of these bonds are
• held for regulatory purposes: for example they count as high-quality liquid assets (HQLA) and are not sold or bought just because of differences in yield
• There are many other ways to gain from (invest in) rising interest rates (Eurodollars, futures,...)
• When you look at FX markets and want to determine forwards, you do not care about government bond yields but usually use swap curves (Libor, Euribor, basis curves). In fact, the higher interest rate currency is expected to depreciate in the future, using this logic (based on (un)covered interest rate parity).

The most important reason why I do not think that there is much you can say in general comes from a paper written by Kenneth Rogoff and Richard Meese. Rogoff explains that their research tested predicting the exchange rate in one year, given the information about what money supplies, interest rates, and outputs are going to be in one year. Interestingly, even in this extreme case of foresight, no economic model was able to beat the simple random walk forecast.

Lastly, in order to buy anything in USD from abroad, you have to initially convert your foreign FX (JPY, CAD,..) to USD in the FX market. The turnover in global foreign exchange (FX) markets reached $6.6 trillion per day in April 2019 according to the latest BIS Triennial Survey. That literally dwarves the average daily value (ADV) of government bond trading. Thus, it’s quite likely that the person buying your foreign currency (JPY, CAD,...) is actually circulating it back to your country or just uses it for general FX market transactions that occur all the time.