Sovereign yields and the risk-taking channel of currency appreciation

Revised version, May 2017

Currency appreciation goes hand in hand with easier financial conditions and compressed sovereign bond spreads, even for local currency sovereign bonds. This yield compression comes from a reduction in the credit risk premium. Crucially, the relevant exchange rate involved in yield compression is the bilateral dollar exchange rate, not the trade-weighted exchange rate. Our findings point to a financial risk-taking channel of currency appreciation associated with the global role of the dollar.

JEL classification: G12, G15, G23

Keywords: bond spread, capital flow, credit risk, emerging market, exchange rate