U.S. Monetary Policy and International Bond Markets

• Published date: 01 December 2019
• Author: SIMON GILCHRIST,VIVIAN YUE,EGON ZAKRAJŠEK
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/jmcb.12667

DOI: 10.1111/jmcb.12667

SIMON GILCHRIST

VIVIAN YUE

EGON ZAKRAJˇ

SEK

U.S. Monetary Policy and International

Bond Markets

This paper analyzes how U.S. monetary policy affects the pricing of

dollar-denominated sovereign debt. We document that yields on dollar-

denominated sovereign bonds are highly responsive to U.S. monetary pol-

icy surprises—during both the conventional and unconventional policy

regimes—and that the passthrough of unconventionalpolicy to foreign bond

yields is, on balance, comparable to that of conventional policy.In addition,

a conventional U.S. monetary easing (tightening) leads to a significant nar-

rowing (widening) of credit spreads on sovereign bonds issued by countries

with a speculative-grade credit rating but has no effect on the correspond-

ing weighted average of bilateral exchange rates for a basket of currencies

from the same set of risky countries; this indicates that an unanticipated

tightening of U.S. monetary policy widens credit spreads on risky sovereign

debt directly through the financial channel, as opposed to indirectly through

the exchange rate channel. During the unconventional policyregime, yields

on both investment- and speculative-grade sovereign bonds move one-to-

one with policy-induced fluctuations in yields on comparable U.S. Trea-

suries. Wealso examine whether the response of sovereign credit spreads to

We are grateful to two anonymous referees and Ken West (Editor) for many detailed comments

and useful suggestions on the initial draft of the paper. We also thank Chris Neely, Argia Sbordone,

Mohamed Shaban, Gretchen Weinbach, and participants at the conference on “Macroeconomic Policy

Mix in the Transatlantic Economy” organized by the European Commission, Federal Reserve Bank of

New York, and CEPR, the 15th Jacques Polak Annual Research Conference organized by the IMF, and

the 2017 conference on “Globalization, Development, and Economic and Financial Stability” organized

by the Asian Development Bank Institute for helpful comments. Harley Du, Lucas Husted, Gerardo Sanz-

Maldonado, Shaily Patel, and Rebecca Zhang provided superb research assistance at various stages of this

project. The views expressed in this paper are solely the responsibility of the authors and should not be

interpreted as reflecting the views of the Board of Governors of the Federal Reserve System, the Federal

Reserve Bank of Atlanta, or of anyone else associated with the Federal Reserve System.

SIMON GILCHRIST is with New York University and NBER (E-mail: sg40@nyu.edu).VIVIAN YUE is

with Emory University, FederalReserve Bank of Atlanta, and NBER (E-mail: vyue@emory.edu).EGON

ZAKRAJˇ

SEK is with Division of Monetary Affairs, FederalReserve Board (E-mail: egon.zakrajsek@frb.gov).

Received February 5, 2019; and accepted in revised form September 13, 2019.

Journal of Money, Credit and Banking, Supplement to Vol. 51, No.1 (December 2019)

C

2019 The Ohio State University

128 :MONEY,CREDIT AND BANKING

US monetary policy differs between policy easings and tightenings and find

no evidence of such asymmetry.

JEL codes:E4, E5, F3

Keywords:conventionaland unconventional U.S. monetary policy,

sovereign bond yields, sovereign credit spreads, financial spillovers,

asymmetric policy effects, risk-taking channel.

AMONG FINANCIALLY INTERCONNECTED ECONOMIES,UNANTICI-

PATED changes in the stance of monetary policy in one country can quickly “spill

over” to other countries. While the debate surrounding monetary policy cross-border

spillovers has a storied history in international economics (see Fleming 1962, Mundell

1963), the 2008–09 global financial crisis and its aftermath—a period during which

the Federal Reserve and many other central banks implemented new and unconven-

tional forms of monetary stimulus—has sparked intense interest in such international

monetary policy spillovers, in both academic and policy circles (see Bernanke 2018).

The canonical view of international monetary policy interactions, as exemplified

by the Mundell–Fleming model, identifies the exchange rate channel as the primary

mechanism through which domestic monetary policy actions affect macro-economic

conditions abroad.1At the same time, a monetary policy easing at home will lower

domestic longer term interest rates and raise prices of risky financial assets in the

home country. With highly integrated global financial markets, investor portfolio

rebalancing efforts will lead to capital flows to foreign countries, putting downward

pressure on foreign longer term yields and upward pressure on foreign asset prices,

thereby easing financial conditions abroad.

In this paper, we contribute to the understanding of this so-called finan-

cial spillover channel. Specifically, using high-frequency price data on dollar-

denominated sovereign bonds, we empirically quantify the transmission of U.S. mon-

etary policy in international bond markets. By focusing on dollar-denominated

sovereign bonds, we are able to analyze how U.S. monetary policy affects sovereign

yields and spreads, a question that is more difficult to address using bonds de-

nominated in local currencies, an asset class for which policy-induced fluctuations

in exchange rates are a direct complicating factor.2Compared with sovereign bonds

1.Accordingto this view,a monetary easing at home lowers the domestic interest rate relative to foreign

rates, inducing a depreciation of the domestic currency. One key implication of the Mundell–Fleming

framework is that a central bank cannot freely adjust its policy rate to stabilize domestic output, while also

maintaining a fixed exchange rate and an open capital account—a trade-off frequently referred to as the

“international policy trilemma” (see Obstfeld and Rogoff 2002). Consistent with this prediction, Obstfeld,

Shambaugh, and Taylor (2005), Goldberg (2013), Klein and Shambaugh (2015), and Obstfeld (2015)

have shown that short-term interest rates of countries with flexible exchange rates have an appreciably

lower correlation with the short-term rate of the “base” country, relativeto countries with fixed exchange

rates. Recently, however, Rey (2013, 2016) has argued that even floating exchange rates will not suffice to

insulate domestic financial conditions from foreign monetary policyshocks—at least not without additional

restrictions on capital mobility—thereby, reducing the “trilemma” to a “dilemma.”

2.Fluctuations in exchange rates caused by changes in the stance of U.S. monetary policy can,

of course, affect yields and spreads on dollar-denominated sovereign bonds indirectly through balance

sheet effects, owing to the presence of a currency mismatch between countries’ assets and liabilities

(see C´

espedes, Chang, and Velasco 2004, Gertler, Gilchrist, and Natalucci 2007). Asan alternative

SIMON GILCHRIST,VIVIAN YUE, AND EGON ZAKRAJ ˇ

SEK :129

denominated in local currencies, dollar-denominated sovereign bonds are also a more

established asset class, which allows us to estimate U.S. monetary policy spillovers

in international bond markets using a richer set of countries and over a longer sam-

ple period. And finally, compared with most of the literature on monetary policy

spillovers, we use a nearly ideal measure of unexpected changes in the stance of

U.S. monetary policy to identify policy surprises. Using these surprises, we analyze

whether the strength and scope of the cross-border spillover effects differ between

the conventional and unconventional U.S. monetary policy regimes.

To compare the transmission of conventional and unconventional U.S. monetary

policy actions to international bond markets, we follow Hanson and Stein (2015)

and Gertler and Karadi (2015) and use changes in the 2-year nominal U.S. Treasury

yield on policy announcement days as a common instrument across the two policy

regimes. In contrast to these two papers, we rely on the intraday changes in the 2-year

Treasury yield within a narrow window bracketing Federal Open Market Committee

(FOMC) and other policy announcements to identify unanticipated shifts in the stance

of U.S. monetary policy.3Implicit in this approach is a highly reasonable identifying

assumption that any movement in the 2-year U.S. Treasury yield in a narrowwindow

bracketing policy announcements is due to the unanticipated changes in the stance of

U.S. monetary policy or the FOMC’s communication regarding the path for policy

going forward.

The paper contains two sets of related empirical exercises. In the first set, we

analyze the response of yields on sovereign bonds denominated in U.S. dollars

to an unanticipated change in the stance of U.S. monetary policy. To do so, we

obtained from the Thompson Reuters Datastream daily secondary market prices of

dollar-denominated sovereign bonds issued by more than 90 countries, both emerging

market and advanced economies, since the early 1990s. Weexploit the cross-sectional

heterogeneity of these data by constructing sovereign bond portfolios along two key

dimensions: duration and credit risk.

Our first set of results documents that conventional U.S. monetary policy is

transmitted very effectively to both shorter and longer duration yields on dollar-

denominated sovereign debt. The spillover effects of conventional U.S. monetary

policy across the sovereign bond portfolios of different durations are much more

uniform compared with the unconventional policy regime. That said, the extent of

empirical approach, one could convertlocal currency bonds into dollar-denominated bonds using FX swap

agreements. However,as documented by Du, Im, and Schreger (2018), there is a significant time-varying

gap between the FX-swap-implied dollar yield paid by foreign governments and the U.S. Treasury dollar

yield, which can confound the measurement of sovereigndefault risk using local currency bonds. As shown

by Hofmann, Shim, and Shin (2017), currencyappreciation—vis- `

a-vis the U.S. dollar—in emergingmarket

economies leads to a narrowing of local currency sovereign bond spreads, with the yield compression

primarily reflecting a lower credit risk premium.

3.Hanson and Stein (2015) and Gertler and Karadi (2015) use daily changes in the 2- and 1-year

U.S. Treasury yields, respectively,to identify monetary policy surprises. The use of intraday data allows

us to rule out the potential reverse causality, a situation in which the daily change in U.S. Treasuryyield,

even on a policy announcement day, may not solely reflect changes in the stance of monetary policybut

may also reflect the endogenous response of policy to changes in the economic outlook or other global

macro-economic or financial shocks.