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As German Bund Yields Head to Zero, They Still Beat US Treasuries

As German Bund Yields Head to Zero, They Still Beat US Treasuries

Sunday, 10 February, 2019 - 08:30

Government bond yields are tumbling across the globe. In Japan, the 10-year yield is minus 0.03 percent, the second-lowest level in the past two years. In Germany, the 10-year bund yield fell to 0.08 percent, the lowest since October 2016. Should panic about recession in the European Union reach a fever pitch, it seems only a matter of time before it dips below zero.

That would only add to the amount of negative-yielding debt outstanding globally. That pile reached $8.9 trillion this week, the most since December 2017, Bloomberg Barclays data show. With that in mind, now’s as good a time as any for a friendly reminder: No, 10-year Treasuries are not a better option for many bond buyers in those regions, even with a nominal yield of 2.63 percent.

That’s because the current cost to hedge currency risk is prohibitively expensive, in large part because of the vast difference in the London interbank offered rate between countries. The benchmark is much higher in the US because the Federal Reserve has raised short-term interest rates while other central banks have dragged their feet. I’ll get to the math in a moment, but after paying to eliminate currency exposure, 10-year Treasuries yield minus 0.29 percent for Japanese buyers. For European investors, it’s minus 0.42 percent, close to the all-time low of minus 0.57 percent.

Viewed this way, it’s clear that domestic debt is still a better option for institutional buyers like pension funds and insurers that are seeking safe assets. Of course, as Bloomberg News’s Richard Breslow points out, if there was mass selling of the US dollar, or a sudden reason to feel bullish, then perhaps some buyers would take a stab at purchasing Treasuries without hedging currency risk. But the Bloomberg Dollar Spot Index has traded in a tight range for months.

Here’s how the hedging works for European investors. They pay both the US Libor rate (now 2.7 percent), in addition to their local Libor rate, at minus 0.31 percent. On top of that, they have to cover the basis, as it’s known, which is about minus 7.5 basis points for euro-based investors. Combined, it’s easy to see how that more than wipes out the advantage of 10-year Treasuries. It would take a foray into US corporate debt to lock in a positive yield.

This dynamic of purchasing local bonds comes when both the US and Germany are in need of more buyers. The swelling budget deficit in the US has been well-telegraphed, and domestic funds have picked up the slack, buying on average about half of each monthly 10-year note offering in 2018, compared with around a fifth in 2010. In Germany, net issuance in government bonds will be significant for the first time since 2014, according to Bloomberg Intelligence. Rates strategist Huw Worthington says to expect a year-over-year swing of almost 70 billion euros in 2019.

In theory, that shift in supply would push yields higher. Indeed, BI models suggest the 10-year bund could reach 75 basis points around mid-year. In practice, it’s not so simple, given the global government bond market is as skewed as it is. Just ask Bill Gross, who seemed to regret his large bet on German yields rising to converge with those in the US.

German yields can stay this low, and it looks increasingly likely that they will. Inflation expectations are plunging, economic growth is slowing and few if any investors expect the European Central Bank to raise interest rates later this year. On top of that, Treasuries don’t look any better. It’s starting to feel as if we’re back in 2016, with talk of “lower for longer” and “secular stagnation.”


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