An unintended consequence of holding dollar assets

Robert Czech, Shiyang Huang, Dong Lou and Tianyu Wang

During the March 2020 ‘dash for cash’, 10-year gilt yields increased by more than 50 basis points. This huge yield spike was accompanied by the heavy selling of gilts by mutual funds and insurance companies and pension funds (ICPFs). Focusing on the latter group, we argue in a recent paper that ICPFs’ abnormal trading behaviour in this period was partly a result of the dollar’s global dominance: ICPFs invest a large portion of their capital in dollar assets and hedge these exposures through foreign exchange (FX) derivatives. As the dollar appreciated in March 2020, ICPFs sold large quantities of gilts to meet margin calls on their short-dollar derivative positions, contributing to the yield spike in the gilt market.


But let’s take a step back. Government bonds issued by developed countries (eg Germany, United Kingdom and United States) are typically viewed as the safest and most liquid assets in the financial system. In crisis periods, these high-quality assets traditionally experience large buying demand from investors and consequently appreciate in value – a phenomenon labelled ‘flight to safety’. In the recent Covid-19 (Covid) crisis, however, there was a global selloff of these liquid, safe financial assets.

This surprising observation has inspired many financial market commentaries and academic studies. For the US treasury market, for example, analyses show that the market disruption was driven by the selling pressure of mutual funds, hedge funds, foreign investors and US households. At the same time, dealer banks were unable to absorb the selling pressure due to binding balance sheet constraints. Only the large emergency intervention of the Federal Reserve helped to stabilise this crucial financial market.

What we do

We complement these insights for the US by providing novel evidence for the UK gilt market. First, we use supervisory data to obtain granular information on the asset and derivatives holdings of UK insurers. To examine the extent to which UK insurers hedge the currency risk of their foreign asset holdings, we regress insurers’ hedging activity in the FX derivatives market on their asset holdings in the respective currency. Next, we combine the supervisory holdings data with information on gilt transactions from the FCA’s MiFID II database, as well as estimated variation margin (VM) demands on ICPFs’ derivatives positions in March 2020 based on the EMIR Trade Repository data. We use these additional data to regress insurers’ VM demands during the Covid crisis on their end-2019 FX dollar hedging positions. Furthermore, we regress ICPFs’ net gilt trading volumes on their VM demands across a range of different derivative types, while controlling for various confounding factors. Finally, we also analyse the impact of ICPFs’ selling pressure on yields in the gilt market, separately for short-term (<=5Y) and long-term (>5Y) gilts.

To recap, the 10-year gilt yield rose sharply by more than 50 basis points during the dash for cash between 10 and 18 March 2020, before it dropped again to previous levels after the Bank of England’s intervention on 19 March 2020 (Chart 1). Using the transaction-level MiFID II data, we show that the large yield spike was accompanied by heavy selling of mutual funds (£4.5 billion) and ICPFs (£3.8 billion), as well as the pre-scheduled gilt auctions of the Debt Management Office of around £4 billion. Importantly, this selling of over £12 billion of gilts in a window of only seven trading days was entirely absorbed by banks and hedge funds.

Chart 1: US$/GBP exchange rate and UK government bond yields

While the selling behaviour and price impact of mutual funds are well documented, the large gilt sales by ICPFs came as somewhat of a surprise given that ICPFs usually tend to be passive, long-term investors in the gilt market. We argue that this abnormal behaviour was partly driven by the global reserve currency status of the US dollar. But why exactly?

What we find

UK insurers held nearly £250 billion of dollar denominated assets in their portfolios at the end of 2019, which equals roughly 12% of their total capital. Insurers hedge these positions by selling US$ forward through FX derivatives (ie they deliver US dollars and receive pound sterling at the end of the contract). The magnitude of these hedges is substantial: our analyses show that insurers initiate a hedge of nearly 50 cents for every dollar of US$ exposure, on average.

During the Covid crisis, however, investors were in desperate need of dollars, and the US dollar saw a 10% appreciation against sterling during the dash for cash (Chart 1). When the dollar appreciated, many UK-based ICPFs received margin calls on their hedging positions – the estimated VM demands on ICPFs’ FX derivatives alone amounted to £6.4 billion. Strikingly, we find that an insurer with an above-average US$ FX hedging position paid £62 million more VM per day during the dash for cash compared to an insurer with a hedging position below the sample median (Chart 2).

Chart 2: Estimated FX variation margin demands (in £ millions) on below-average (blue line) and above-average (red line) US$ FX derivative hedgers

Next, our findings reveal that ICPFs sold large quantities of gilts when they had to meet VM calls during the dash for cash. More precisely, we show that ICPFs’ gilt selling was mostly driven by VM calls on their FX derivatives, while VM demands on other prominent derivatives types – such as interest rate swaps or inflation swaps – only played a minor role. We also find that ICPFs followed a liquidity ‘pecking order’ and predominantly sold relatively liquid gilts.

Finally, we show that ICPFs’ selling pressure also had a significant impact on yields, particularly for long-term (>5Y) gilts: a one-standard-deviation increase in ICPFs’ selling is associated with a 30 basis points increase in long-term gilt yields during the dash for cash.

Financial stability implications

All in all, our findings reveal a novel mechanism through which the reserve currency status of the dollar can have a large impact on government bond yields outside the US. Non-US institutions hold huge amounts of dollar denominated assets and hedge these exposures by selling dollars forward through FX derivatives. However, the dollar tends to appreciate against other currencies in crisis periods, leading to large margin calls on these FX hedging positions. Institutions then sell their safe and liquid assets to meet margin calls or to replenish their liquidity buffers, thereby contributing to yield spikes in the domestic government bond market.

It is important to note, however, that investments in dollar denominated assets and the accompanying FX hedges provide desirable portfolio diversification for non-US investors, in particular ICPFs. Against this backdrop, the question arises whether policymakers could encourage ICPFs to better manage their liquidity in crisis periods by enhancing the sector’s risk monitoring and liquidity preparedness. Furthermore, margin calls could be made more predictable, eg through more transparent margin calculations. Such measures may help to prevent a similar liquidity drain in the ICPF sector in future downturns, and mitigate negative effects of a dollar appreciation on prices and liquidity in the UK gilt market.

Robert Czech works in the Bank’s Research Hub, Shiyang Huang works at Hong Kong University, Dong Lou works at LSE and CEPR, and Tianyu Wang works at Tsinghua University.

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