We expect the international investment community to continue purchasing U.S. financial assets, and in particular to continue financing the U.S. budget and trade deficits.
Not only are the yields on U.S. government bonds and securities higher than those in most developed economies, but there is the additional currency return of U.S. dollar investments.
The yield on a 10-year Treasury yield is trading between 4.5% and 4.6%, which is roughly the same as debt issued by governments in the U.K., New Zealand and Australia.
The difference is that the currencies in those countries have lost value to the dollar over the past three months. There is always currency risk in any investment.
One can observe moves in the EUR/USD one-month or three-month at-the-money implied volatility to understand just how challenging it is for investors or firms to properly hedge currency volatility as regime change is causing the yield curve to reset higher and the dollar to appreciate.
Currency hedging
Unlike government bond yields, currency returns are in no way guaranteed of continuing forever.
At some point, it may be prudent to adopt a currency-hedging strategy that relies on the global supply chain.
Because of the shape of the U.S. yield curve, with U.S. money market rates higher than all but the U.K., hedging a currency exposure has become prohibitive in all but a few cases.
This dynamic is based on a simple model in which the cost of hedging is proxied by the short-term interest rate differential between the currency pairs.
In the case of Japan, where the implied three-month interest rate is 0.33%, the expenditure of the hedge is more costly than the yield pickup gained in a Treasury bond (rather than a Japanese government bond yielding only 1.2%).
At this time, however, the U.S. economy is leading the developed world out of the pandemic, and its financial assets offer the most liquidity and highest returns available.
That position suggests that the bet is on the dollar’s continued strength relative to Japan’s moribund economic growth and the attractiveness of U.S. financial assets, with the need for hedging made according to investment specifics.
We expect that Japan will remain the largest purchaser of U.S. debt. But we also expect the financial community to be prepared to adjust its hedging strategies to the possibility of disruptions to trade and the willingness to provide financing.
