Declining currency volatility helps explain the flat liquidity premium observed in 2004-2005. Just as all investors need to be compensated for higher expected inflation, foreign investors in U.S. securities need to be compensated for the currency risk they are assuming. The greater the volatility of the dollar, the greater the probability it will decline over the life of the bond and the more compensation will be required.
Japan has acted in the role of investor of last resort in the U.S. securities market by virtue of its massive and perennial trade surplus with the U.S. as well as its willingness to sell yen and buy dollars to prevent the yen from strengthening against other currencies in the dollar bloc, including China, South Korea, and Taiwan. While these massive purchases have been given credit for keeping U.S. long rates lower and the dollar firmer than they would have been otherwise, we can see the trend of declining U.S. long-term rates was in place well before the Bank of Japan went on its buying spree.
If the Bank of Japan’s manic purchases of U.S. Treasuries and other securities cannot account for the decline in the liquidity premium, what can? The answer appears to be declining currency volatility. If we map the liquidity premium against the volatility of three month non-deliverable forwards on the yen over this period, we see a convergent decline marred only by the dollar’s abrupt sell-off against the Euro in the fourth quarter of 2004.
The message is clear and has been received by the central banks: One of the best ways to keep long term interest rates low without igniting inflation is to keep currency volatility low. This means moving toward firm exchange rates.
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