Sovereign yields and the risk-taking channel of currency appreciation

Working Papers No 538
January 2016

Currency appreciation against the US dollar is associated with the compression of emerging market economy (EME) sovereign yields. We find that this yield compression is due to reduced risk premiums rather than expectations of interest rates already priced into forward rates. We explore a model which ties together dollar credit to EME corporates, sovereign tail risks and global investor portfolio adjustments driven by economic capital constraints. Consistent with our model, we find no empirical association between currency appreciation and sovereign spreads when we use the trade-weighted effective exchange rate that is unrelated to the US dollar.

JEL classification: G12, G15, G23

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