As bond yields dwindled into negative territory around the globe, the United States remained a haven of positive yields, with US Treasury notes yielding more than 2% and junk bonds a dreamy 6%.
But unless foreign investors were willing to take a chance on dollar exchange rates and leave the purchase unhedged, the costs of hedging that exposure, at 350 basis points, made the investment prohibitive. Those costs could turn a positive yield of about 2% to a negative yield of 1%.
When the US Federal Reserve was intent on raising rates every other meeting, hedging costs had to anticipate those rate hikes. But after the Fed pivoted in January, first holding rates steady and eventually cutting them by a quarter point in July, those hedging costs have gone down and the prospect of further cuts is edging them lower.
Fed ambivalent about more cuts
Further cuts are far from a sure thing, however. Fed chair Jerome Powell was somewhat ambivalent about the number of rate cuts ahead. At one point in his post-meeting press conference in July he suggested there was a bias to further cuts — but then he said one cut doesn’t imply the start of a series.
Hedging costs had droppedOpens a new window to 275 bp ahead of that meeting and May registered the strongest foreign buying of US bonds in nearly a year.
Still, a European investor was getting a minus 0.8% yield on a hedged U.S. Treasury bond that was yielding 2.05% unhedged and Japanese investor, minus 0.6%
At the same time, 86% of German government debt showed a negative yield, and even half of Spanish government debt. A few years ago, both yields were positive and the only concern was the wide gap between German and Spanish debt.
Markets bet Fed will buckle
Investors still need to see one or two more rate cuts in the US to make hedged yields positive, or at least not more negative than domestic bonds in Europe or Japan. Despite Powell’s reluctance to commit to further accommodation, fed funds futures markets are predicting more than a four-fifths likelihood that US rates, currently at 2.00-2.25%, will see at least two more quarter-point cuts by the end of the year, if not three.
In the meantime, investor concerns about growing trade tensions are driving down yields on 10-year U.S. Treasury bonds, which reached 1.738% in early August, their lowest point in nearly two years.
This exacerbated the inverted yield curve the Fed was trying to correct with its cut because it kept long-term rates below short-term rates. The gap reached its widest point since April 2007. That means the Fed will feel pressure to cut rates in September after all.
US must cut rates
The other factor: What are other central banks doing? The European Central Bank, for instance, has signaled a packet of measures to loosen monetary policy at its next meeting in September, including lowering key interest rates further into negative territory.
Presidential adviser Peter Navarro has called upon the FedOpens a new window to cut rates another three-quarters of a point by the end of the year to bring them a full point lower. The US must do this to get in line with other countries, he said, and specifically to match declining currencies in China and Europe.
If by now you have the impression that central banks are in uncharted territory, that’s no accident. In such a situation, investing in safe bonds that have a negative yield or hedging exposure that produces a negative yield might look like the best optionOpens a new window .
In the meantime, foreign investors are piling into US corporate debtOpens a new window and not hedging it. Yields on these bonds have fallen, but less than on Treasuries, which are impacted by the safe haven effect.
Investors are not hedging the corporate bonds in the assurance that the dollar will remain stronger than their domestic currency amid this flurry of interest-rate cutting.