Cooling hedging costs take sting out of US-dollar debt investment
Buying US government bonds could soon become a more enticing prospect for overseas investors as the sky-high cost of protection against dollar gyrations starts to recede.
For months, foreign investors looking to buy safe US assets have faced a tough choice: buy pricey protection against swings in the dollar and earn tiny, even negative yields, or grab higher returns by leaving the risk of a weakening dollar unhedged.
Since 2018, many overseas investors have chosen the latter option because so-called hedging costs have proven prohibitively expensive. Now, that is starting to crack.
“Clearly if we have [0.75 percentage points] of Fed rate cuts over the next six months, that would change the hedging economics very meaningfully,” said David Riley, chief investment strategist at BlueBay Asset Management. If, at the same time, longer-term bond yields picked up from their lows, “then that would be quite a powerful combination and make US assets more attractive to overseas investors”, he added.
Since the Federal Reserve opened the door to interest rate cuts in April, the trade-weighted dollar has come under pressure, sliding from its most expensive levels in two decades. The tilt towards easier monetary policy — coupled with extremely dovish language from the Fed in the ensuing months — has also fuelled expectations of a further move lower in short-term rates.
Markets are pricing in a 77 per cent chance the Fed will cut its benchmark interest rate by a quarter of a percentage point when the central bank convenes this week, according to futures prices compiled by Bloomberg. If chair Jay Powell complies, traders are betting he will concede to at least two more cuts by year-end.
Hedging costs have fallen as a result, but they remain elevated enough that many foreign buyers still face a loss when buying US Treasury debt.
European investors with a three-month dollar hedge now earn a roughly minus 0.8 per cent yield on a 10-year US Treasury, according to Bloomberg data, compared with an unhedged yield of 2.05 per cent. Hedged Japanese investors earn minus 0.6 per cent.
Still, Nikkei reported this week that the world’s largest pension fund, Japan’s Government Pension Investment Fund, has already shifted course when it comes to protecting itself against currency fluctuations. In the fiscal year ending in March, the GPIF snapped up hedged European and US bonds.
But according to Adam Cole, the chief currency strategist at RBC Capital Markets, few are likely to follow in the GPIF’s footsteps for now. Rather, the Fed will have to cut more deeply and over a longer period of time if hedging costs are to move low enough for more of them to put hedges back on their foreign exposures.
In fact, he noted that the current expected path of US rates brings hedging costs only back to levels last seen in early 2018 — a time when Japanese investors started going “naked” into trades.
“This is not a normal easing cycle because the Fed is expected to deliver a quick burst of easing and then retreat to the sidelines,” said Mr Cole. “It’s not enough to see a wholesale increase in hedging ratios.”
Another factor blunting the effect of lower benchmark US interest rates is that the Fed is not alone in cutting interest rates this year. True, the US has more room to cut rates than other central banks whose benchmark rates are close to or even below zero, but markets are “going into a global synchronised slowdown in rates”, as Jon Hill at BMO Capital Markets put it.
Last week for instance, Mario Draghi, president of the European Central Bank, reiterated his intention to ease policy in the coming months.
One way for foreign investors to get round the pain of currency hedging is to buy lower-rated, riskier US debt — giving them yield while allowing them to insure themselves against destabilising currency fluctuations.
According to data compiled by Daniel Sorid at Citi, investors in Japan, South Korea and Taiwan can pick up anywhere between 0.16 and 0.53 percentage points more yield than local 10-year government securities by investing in US corporate bonds rated single A, even after factoring in the cost of a one-year currency hedge. Those bonds, subject to the same currency hedge, offer 0.48 percentage points more in yield than 10-year German government bonds.
But Mr Sorid warned that the “reach-for-yield” dynamic brought its own risks.
“Foreigners’ continued reliance on the US corporate bond market to provide higher yielding, long-duration income has encouraged US companies to binge on debt for as long as they can,” he said. “That is of some systemic concern.”