· Foreign demand has helped drive Treasury yields lower and support prices over the past year, though increasing hedging costs may prove problematic moving forward.
· Demand from indirect bidders continues to be strong at Treasury auctions, muddying the argument that higher hedging costs may cause foreign demand to weaken.
· For now, foreign demand remains supportive of domestic bond prices.
Overseas investors remain a key support of domestic bond prices and have helped to drive the 10-year Treasury yield to a recent level of 1.55%. Although weaker than expected economic growth over the first half of 2016 and sluggish growth in Europe and Asia have contributed to bond strength, foreign demand for Treasuries has played a large and increasing role in Treasury strength.
Record amounts of monetary stimulus from central banks around the world have led to low or even negative yields for government debt in many developed nations, with Fitch data indicating that $11 trillion in debt is now trading at negative yields worldwide. The yield differential between 10-year U.S., Japanese, and German bonds shown in Figure 1 makes it easy to see why foreign investors have shown more interest in U.S. debt this year.
HEDGING COSTS INCREASE
U.S. Treasuries would seem a logical choice for overseas investors seeking the safety of government bonds, given their yield advantage. However, foreign investors have one additional risk to factor in—currency movements. 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, it is possible that 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, overseas investors may choose to hedge their U.S. dollar investments via currency futures by buying dollars at the spot rate, and simultaneously selling currency forward to lock in a given exchange rate over a selected period of time. In this way, currency hedging can help 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.