Will the natural order of currency-hedged bonds be upended?
Will the natural order of currency-hedged bonds be upended?
Over the last few months, the US 10-year government bond yield has risen sharply, and at 2.4% (as of 31 March), is the highest since early 2019.
Across the developed markets, US bonds offer some of the highest yields. You would think this may lead to strong demand, especially from Europe, where yields remain significantly lower. But this might not turn out to be the case.
A large share of international investors purchase foreign bonds on a currency-hedged basis to remove any risk from currency fluctuations. Such fluctuations can make a big difference to the overall risk of bond investments.
For these investors, it is not the nominal bond yield that matters, but rather the yield after taking account of currency hedging costs. Once these costs are factored in a very different story emerges.
The effect of rising US dollar hedging costs
The chart below shows that after adjusting for currency hedging, the US 10 year yield is barely positive for euro area investors. And is a lot lower than the yield available on German bunds. Rather than offering a yield “pick-up”, they offer a yield deficit.
Why is there such a large difference between nominal and currency-hedged yields? Importantly, currency hedging rates are mainly based on the difference between the short term interest rates of two countries.
In the US, the Federal Reserve (Fed) is on a mission to bring down US inflation. After hiking in March, the central bank has communicated a series of rate rises. The market has taken notice, pricing in rates being a full 2.5 percentage points higher between now and April 2023.
In Europe, the European Central Bank (ECB) has indicated that rate hikes might also commence this years. However, the trajectory is much shallower, with only 0.7% of rate hikes priced in over the next 12 months (as of 31 March).
When taking account of the fact that US short rates are already higher than European ones, this takes the annual hedging cost to 2.3%, when using one-year EURUSD forwards.
The shift in the relative attractiveness of yields has been rather sudden. In November 2021, the German 10 year yield was deeply negative at -0.3%. The US 10 year yield, after adjusting for currency hedging cost, stood at 0.4%, providing a handsome yield pick-up for euro investors.
But as US rate hike expectation have increased significantly, the cost of currency hedging has risen, making US yields less attractive on a hedged basis. At the same time, euro area bond yields have increased as well, with the German 10 year yield now firmly positive at 0.6%.
With these kind of yields at the offer, US bonds have far more limited appeal for hedged euro investors.
Hedged yields and demand for foreign bonds
Historically, what has been the impact of attractiveness of hedged US yields on euro area investors’ bond purchases?
We should emphasise here that not all investors purchase foreign bonds on a currency hedged basis. Less risk averse investors might be willing on take currency exposure, as long as the yield advantage is large enough.
The figure below shows the difference between the German 10 year yield and the currency-hedged US 10 year yield (blue line).
A positive value means that domestic yields are more attractive for euro area investors, and a negative value that hedged US yields are more attractive.
The green line shows foreign bond purchases by euro area investors in billions of euros over a rolling 12-month period.
Since 2014, euro area investors have been on a buying spree of foreign bonds, with the cumulative purchases amounting to €2.8 trillion. A large percentage of these flows have gone to US bonds.
However, the outflow has not been consistent, with the attractiveness of hedged US yields having an impact on the flows. In the previous Fed hiking cycle in 2016-2019, US bonds also became unattractive for hedged euro investors.
Consequently, the annual purchases fell from €470 billion in 2017 to just €100 billion in 2018.
With a similar situation developing in 2022, it is likely that the demand for foreign bonds falls once again. Furthermore, there is an important difference between the current and the previous Fed hiking cycle.
In 2018, the net issuance of euro area government bonds was less than the European Central Bank’s (ECB) bond purchases. So the available pool of domestic bonds was actually shrinking for euro investors.
In 2022, the ECB is likely to wrap up its asset purchases. At the same time, issuance remains brisk, given the need to finance the euro area pandemic recovery plan and greater military spending.
As a result, net issuance looks set to increase, creating more opportunities for hedged euro investors to snap up domestic bonds.
Hedged yields also matter to Japanese investors
There is another group that is affected by the changes in the attractiveness of global hedged yields: Japanese investors.
With their own domestic yields stuck at zero, Japanese investors have been major buyers of international bonds, most often denominated in dollars or euros, given the size and depth of these two markets.
In 2021, hedged US yields were far more attractive for them than hedged euro yields. However, the sharp increase in US dollar hedging costs has upended this hierarchy.
From their perspective, hedged euro yields have increased, whereas hedged US yields have fallen sharply. The hedged US 10 year yield is now below the Japanese 10-year yield.
Historically, Japanese investors have purchased more dollar bonds than euro bonds. However, between 2017 and 2018 – the last time hedged euro yields had a big advantage over hedged dollar yields – their purchases of euro bonds far exceeded those of dollar bonds.
In fact, they became net seller of dollar bonds in that period.
With a similar dynamic in play, Japanese demand for euro bonds could once again increase, at the expense of demand for dollar bonds.
In sum, US bond yields are starting to look very attractive, but for a lot of international currency-hedged investors, US bonds are quickly losing their appeal because of currency hedging costs. And if history is any guide, demand for them could fall in 2022.
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