Convenience Yields and Exchange Rate Puzzles

We introduce safe asset demand for dollar-denominated bonds into a tractable incomplete market model of exchange rates. The convenience yield on dollar bonds enters as a stochastic wedge in the Euler equations for exchange rate determination. This wedge reduces the pass-through from marginal utility shocks to exchange rate movements, resolving the exchange rate volatility puzzle. The wedge also exposes the dollar’s exchange rate to convenience yield shocks, giving rise to exchange rate disconnect from macro fundamentals and a quantitatively important driver of currency risk premium. This endogenous exposure identifies a novel safe-asset-demand channel by which the Fed’s QE impacts the dollar and long-term U.S. Treasury bond yields.