With Friends Like These, Who Cares About 3% Treasuries?
(Bloomberg Gadfly) -- 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.
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.
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.
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.
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.
For Europe, bondaggedon looks like it will be delayed for a good while yet.
Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.
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