Key Takeaways
- The 10-year Treasury’s yield advantage to the German bund is back to pre-election levels, though it remains elevated relative to history.
- Low yields in Europe and other developed nations will likely continue to put downward pressure on Treasury yields.
Sam Zell: Real Estate Investment Philosophy
Year to date, yields have moved higher for many developed foreign government bonds, while Treasury yields have moved lower. Foreign demand has been a source of strength for Treasuries in recent years, as low overseas yields have pushed foreign investors toward relatively higher yielding U.S. bonds. The 10-year Treasury’s yield advantage to the German bund reached a 28-year high earlier in 2017, but a combination of rising yields in Germany and falling yields in the U.S. has pushed this advantage back to pre-election levels. Although this declining differential may cause some to worry that foreign demand may begin to fade, it is important to note that the yield advantage of Treasuries to other major foreign bond markets remains substantial by historical terms.
The yield advantage of U.S. Treasuries, coupled with strong credit quality, would seem to make them a logical choice for foreign investors. Central bank stimulus in the Eurozone has pushed rates for even peripheral countries with lower credit ratings below those of higher-quality U.S. Treasuries. As Figure 1 shows, even after accounting for the fact that yields for all G7 nations, other than the U.S., are higher year to date, the 10-year Treasury still offers a yield premium, even to lower-rated nations such as Italy.
Hedging Costs
The figure above clearly shows the value of Treasuries relative to other developed nations, but yield isn’t the only factor that foreign investors have to consider when investing in the U.S. When a foreign investor purchases a Treasury security, they have to make the purchase in U.S. dollars. If the dollar depreciates relative to the investor’s home currency, the investor receives less of the local currency back for each dollar, reducing total return. Given that exchange rates can be volatile, a depreciating dollar could wipe out a significant portion (or all) of any advantage the investor would see from investing in the U.S., especially with interest rates at low absolute levels.
For this reason, many foreign investors choose to hedge their dollar-denominated investments by using currency futures. To do this, an investor would purchase dollars at the current exchange rate (known as the “spot rate”), and simultaneously sell their local currency forward to lock in a given exchange rate over a selected period, helping to reduce the risk of unforeseen currency swings. However, a currency hedge involves a cost and this cost can fluctuate over time due to a variety of factors.*
Figure 2 shows the relative value of Treasuries including hedging costs for Japanese investors. Last summer, falling Treasury yields and increasing hedging costs meant that Treasuries were less attractive to Japanese investors. Though hedging costs haven’t changed much since that time, rising U.S. yields have made the trade more attractive.
Checking The Data
Even after adjusting for hedging costs, other financial and non-financial sources of risk can have an impact on foreign demand for Treasuries as well. For this reason, it is also important to look at data sources that show actual purchases or holdings of Treasury securities by foreign investors, such as Treasury auction results and the monthly Treasury International Capital (TIC) System report, to gauge whether perceived value is translating to actual demand.
The data on both of these fronts continue to support the idea that foreign demand remains strong. Indirect bidders, which include foreign investors, continue to be a factor in recent Treasury auctions as shown in Figure 3. Purchases from indirect bidders have been 60% or higher for each of the 10-year Treasury auctions held in 2017, compared to an average of 45% over the past 10 years.
TIC data are delayed by a couple of months, but the latest release in July (which captures May results) shows that foreign nations continue to be large holders of Treasuries. Total foreign holdings increased by $50 billion from April to May 2017, approximately $10 billion of which was from China, which has seen Treasury holdings increase in the last four consecutive reports.
Conclusion
Though U.S. yields have fallen year to date, and yields in many other developed nations have risen slightly, the yield advantage that U.S. Treasuries hold relative to foreign bonds remains large. We believe foreign yields, which remain at low absolute levels, may continue to exert downward pressure on U.S. yields in 2017, helping to offset the potential for a significant move higher in rates driven by Federal Reserve policy, continued economic growth, and the potential for pro-growth initiatives such as tax cuts (see this week’s Weekly Market Commentary). Given these factors, we continue to believe our expectation for the 10-year Treasury yield to end 2017 within the 2.25% and 2.75% range, with the potential for 3% if meaningful fiscal stimulus is enacted, remains reasonable.**
Article by LPL Financial
