US: Foreigners have fled negative rates and flocked to US fixed income – Deutsche Bank

George Saravelos, Strategist at Deutsche Bank, suggests that a remarkable hunt for yield has taken place over the last few years as foreigners have fled negative rates and flocked to US fixed income to take advantage of positive rates.

Key Quotes

“Currency hedging these purchases has been a popular strategy: investors buy long-end bonds and use short-dated forwards to eliminate the FX risk.

Yet something significant has happened in recent months: buying 10-yr US treasuries is no longer profitable. It is not only Europeans or Japanese, there now isn’t any global fixed income investor that can make decent money by buying hedged USTs. Even more remarkably, the reason behind this lack of return isn’t that long-end yields have compressed: the rate differential between the US and the rest of the world has stayed quite stable. Instead, it is diverging central bank policy (Fed hike vs cuts elsewhere) and the widening in crosscurrency basis that now makes it very costly for investors to hedge. We draw a number of conclusions from these simple observations.

First, it is hard to see the relentless foreign buying of hedged US fixed income continuing at the same pace. Unless other bond yields decline deep into negative territory (they are already zero), there may be limits to how much more UST yields can compress.

Second, the rise in forward costs is bullish USD. If investors want to pick up AAA yield, they will have to do so unhedged, which will generate demand for dollars. If they don’t want FX risk, investors will have to buy higher-yielding corporate bonds or other riskier US assets.

Finally, cross-currency basis and the US short-end may prove material drivers of global capital flows going forward. On the one hand, the widening in crosscurrency basis is essentially a “tax” on hedging costs distorting global capital flows. On the other hand, a Fed tightening will make FX hedging even more expensive, counter-intuitively forcing investors to increase, rather than reduce, FX, credit or duration risk.”