Global financial markets are reacting to the resurgence of the coronavirus in Europe, the United States and elsewhere and the prospect of increased U.S. postelection fiscal spending.
Though not at the level of perceived risk reached at the height of the outbreak and the lockdown in March and April, the MOVE index of U.S. bond market volatility has moved higher in recent days. This should be understood as an increase in the perceived risk of a U.S. bond market selloff if Congress decides to extend or supplement unemployment insurance once it returns after the election.
Seeking a safe haven
A European resurgence of infections, another round of lockdowns and slowing economies have prompted a drop in equity markets and an increase in the safe-haven demand for German government bonds. The yield on 10-year Bunds has fallen 20 basis points lower to negative 0.6%, which should indicate a financial system awash in liquidity, but in an economy facing an 8% decline in growth this year.
Hedging the currency risk of owning a U.S. security
Rather than settle for a return of near zero or less on a domestic fixed income investment — which is the case for some European and Japanese investors – international investors can look to high-yield (higher risk) markets in Italy and Spain or to the commodity currencies in the dollar bloc (Australia and New Zealand), while hedging away the currency risk.
But even with yields of less than 1%, fully hedged U.S. Treasury bonds have retained their attractiveness to foreign investors looking for a safe-haven investment. The purchase of a fully hedged U.S. 10-year Treasury security offers yield pickups ranging from 80 basis points for a euro-based investor to 40 basis points for a yen-based investor relative to the yield of a German or Japanese government bond.
The cost of hedging away the currency risk of owning a foreign bond is based on the short-term interest-rate spread between two currencies. And because of Federal Reserve rate cuts and the compression of money-market rates resulting from the global manufacturing recession that began in 2018, the cost of currency hedging has declined for foreign investors.
The latest episode of Federal Reserve rate cuts and the sharp decline in U.S. money-market rates has been the impetus for increasing the hedged return on 10-year U.S. Treasury bonds even as U.S. long-term yields have declined.
Foreign purchases of U.S. Treasuries
Nevertheless, actual purchases of U.S. Treasuries have been in decline during the pandemic. We attribute the falloff in demand for Treasuries to the economic shutdown during the initial phase of the pandemic and the decline in consumer spending, which halted the import of foreign goods at U.S. ports.
In normal times, foreign exporters park their receipts from U.S. sales in Treasury securities, earning the excess interest-rate return of dollar-based securities. With foreign trade halted, the commercial demand for Treasuries deteriorated and 10-year yields moved marginally higher. And as we mentioned, in recent weeks U.S. long-term yields are now increasing because of the prospect of a fiscal stimulus.
Because lower interest rates will be necessary for funding pandemic relief programs and because foreign demand for U.S. securities adds to the downward pressure on long-term interest rates, this strongly implies that the federal government needs to put in place scientific-based policies to end the pandemic and restore relations with our trading partners.
The global growth channel will be a vital part of the coming economic recovery. This also implies additional asset purchases by the Federal Reserve if interest rates at the long end of the curve rise or another round of lockdowns because of the pandemic becomes necessary in the U.S.
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