Mind the gap! Over the course of 2018, the US Federal Reserve is on course to raise the federal funds rate by 25 basis points in each quarter (we reckon there will be a rate rise agreed at the meeting of the Federal Open Markets Committee (FOMC) on 18-19 December). The target for the federal funds target rate is currently 2%-2.25%.
The US federal funds target rate is already at 2%-2.25% while in Japan and Europe interest rate normalisation has yet to begin
As neither the European Central Bank (ECB), nor the Bank of Japan (BoJ) has begun normalising interest rates and as they are unlikely to do so in the foreseeable future, a significant gap is opening up in short-dated interest rates. As US interest rates rise so does the cost of foreign exchange (FX) hedging for investors whose base currency is the euro or Japanese yen. This higher cost of FX hedges makes US bonds more expensive on a hedged basis for foreign investors and is likely to affect flows of capital within the G3, with potentially greater inflows into European bonds (10-year German Bunds for example yield more than US Treasuries on a USD-hedged basis).
US Treasuries currently yield 3.18%; hedged back into euros they yield -0.27%….
The chart of the week shows the yield an investor in a particular region (US, EU (eurozone), UK, Japan, China) would obtain when buying bonds in other regions after hedging the bonds back into their base currency (using a 3-month foreign exchange forward contract, annualised).
For example, after hedging the US dollar FX risk back into euros, an investor in the EU who bought a US 10-year Treasury bond would hold an instrument yielding -0.27%. For US-based investors, after hedging the euro currency risk, eurozone bonds offer better yields than US bonds (they also offer a better roll-down given the steeper eurozone yield curve).
Japanese investors looking for yield among high quality sovereign bonds would also obtain a more attractive yield pick-up in eurozone bonds than in US Treasuries.
Chart of the week: Table showing the yield after integration of FX hedging costs* for investors buying non-domestic sovereign debt
In 2019, the cost of hedging US dollar exposure is likely to rise further for EU and Japanese investors
Over the next year , we believe we will see this paradigm become even more pronounced. That is, if, as we expect, the FOMC raises rates in each quarter of 2019 the federal funds target rate could be at 3.25%-3.50% at the end of 2019. The gap between short-dated US interest rates and official interest rates in the eurozone and Japan is likely to widen significantly in 2019, potentially favouring eurozone bonds for US and Japanese investors.
* Cost of the foreign exchange hedge is calculated using a 3 month foreign exchange forward contract, annualised BNP Paribas Asset Management
Source: BNP Paribas Cross-Asset Strategy team, as at 14/11/2018
For previous graphs of the week, click here.