The Hedge Is Your Friend

Who Cares About a 3% 10-Year?

Japanese investment and helpful central banks can delay bondageddon in Europe.

The Eiffel Tower stands illuminated on the city skyline as the sun sets over skyscrapers in La Defense business district in Paris, France. Photographer: Christophe Morin

It happened. A U.S. 10-year at 3 percent is here, dragging the rest of the world's bond yields up with it.

But the damage isn’t equally spread. Europe and Japan are anchored by some serious reluctance to let benchmark borrowing costs rise.

Neither the European Central Bank nor the Bank of Japan look set to deviate from their negative interest rate policies anytime soon. The contrast with Federal Reserve couldn’t be sharper, with Chairman Jerome Powell forecasting three to four quarter-point rate increases over the next year.

That’s not the only gulf. The difference between the U.S. and the other two major global bond markets could get a lot wider.

Different Perspectives

Rising U.S. yields have not stopped peripheral European yields from falling this year

Source: Bloomberg

Though 10-year German yields have doubled this year, they’re still only at 0.65 percent. This has pushed the spread to U.S. 10-year yields to more than 235 basis points from 170 basis points in July.

But it is in the two-year where the gap is the widest. There, the spread between the U.S. and Germany has widened to over 300 basis points.

When U.S. Yields Rise, and Europe Stands (Relatively) Still

Treasuries finally offer some decent yield, but for foreign investors there's a currency risk to deal with

Source: Bloomberg

A three percentage point difference in interest rates is a big gulf in the cost of financing. You may think that this would completely undermine the attractiveness of European fixed income for investors who have been starved for yield for years. You’d be wrong. What matters is the hedging strategy

A 3 percent 10-year yield looks attractive for a Japanese investor facing 10-year yields at home of just 0.05 percent. The issue is the currency risk – if the yen were to strengthen versus the dollar investors could suffer a substantial capital loss. The problem is that, as U.S. interest rates rise and Japanese rates remain static, hedging costs for U.S. dollar investments become more expensive.

Ouch

The cost of hedging U.S. dollar assets for Japanese investors has climbed a lot

Source: Bloomberg

Which is where European bonds suddenly become a lot more attractive. The currency-hedged yield on 10-year French government debt is 117 basis points, compared to just 54 basis points for hedged U.S. 10-year notes. On this basis, the debt of Spain and Italy are even more attractive, so this seems enough to get Japanese investors  over the credit quality hurdle and start buying. 

This is the impact of negative European money market rates. And given that the German 2-10 year yield curve, at 120 basis points, is twice as steep as the U.S. curve, there’s an extra benefit for longer maturities.

French Allure

French government bonds offer a significant pickup for Japanese investors on a currency-hedged basis

Source: Bloomberg

Calculation: French 10-year bond yield minus three-month Euribor plus three-month yen Libor plus (Yen basis swap - Euro basis swap)/100

So it is no surprise to see the 2018-2019 financial year investment plans of the large Japanese life insurers showing a renewed interest in buying foreign bonds on both a hedged and unhedged basis. In March, life insurers bought a net 764 billion yen ($7.1 billion) of overseas securities, the second-highest monthly net purchase amount ever – and the trend looks to be continuing in April. 

Renewed Appetite

It's the start of the Japanese financial year, and life insurers are buying more foreign bonds

Source: Japan Ministry of Finance, Bloomberg

For Europe, bondaggedon looks like it will be delayed for a good while yet.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Marcus Ashworth in London at mashworth4@bloomberg.net

    To contact the editor responsible for this story:
    Jennifer Ryan at jryan13@bloomberg.net

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