Why is the USD hedging cost eating my lunch?

global perspectives

Why is the USD hedging cost eating my lunch?

Charles St-Arnaud - Senior Investment Strategist

Charles St-Arnaud

Senior Investment Strategist

The US is currently the highest yielding country in developed markets. However, while this may appear very appealing to foreign investors, there is the cost of hedging against the currency risk to consider.

The current situation, where the cost of hedging completely eliminates the yield advantage of an asset, is very unusual and is being driven by a number of different factors. In our view, the hedging cost itself is mainly being driven by the short-term interest rate differential and it is unlikely this will ease in the coming months, as central banks continue to diverge in terms of policy.

Our view is that the current situation could deteriorate further, as the premium to borrow USD on the swap market is likely to remain elevated at least until the end of the year, after which we should expect some normalisation.

Investors in low-yielding countries are eyeing the higher US yields with envy. However, the high hedging cost discourages them from taking advantage of the discrepancy. As a result, investors are exploring ways to improve their returns. To improve returns on dollar-denominated assets, investors will need to accept extra risks, either in the form of FX risk or credit risk; there is no free lunch.

 

Investment implications

  • Yields on 10-year US Treasury1 (UST) are currently higher than the equivalent yield on Bunds, Japanese government bonds (JGBs), and usual high yielders like Australia.
  • While the yield differential may appear very appealing to foreign investors, it is much less the case once an investor decides to hedge against the currency risk. For US investors, the situation is inversed, as they are getting paid to hedge their EUR exposure.
  • The high cost of hedging USD exposure could explain why the USD has failed to appreciate more, considering the very positive interest rate differential in its favour.
  • The current situation is unusual and it is our view that it could deteriorate further. The premium for USD is likely to remain elevated at least until the end of 2018.

 

What is happening in the US?

Strong growth in the US, coupled with increasing inflationary pressures and the continued removal of the monetary policy stimulus by the Federal Reserve, have transformed the US into the highest yielding country in developed markets. At around 3.25%, yields on 10-year US Treasury (UST) are about 270bp higher than the equivalent yield on Bunds, over 300bp higher than Japanese government bonds (JGBs), and higher than usual high yielders like Australia by almost 50bp.

However, while the yield differential may appear very appealing to foreign investors, it is much less the case once an investor decides to hedge against the currency risk. As such, for example, a EUR-based investor who decide to buy a 10y UST and fully-hedge the USD position would only get a yield of about 0% currently. It was even negative as recently as September. This is quite below the 3.25% that the investors would have initially hoped for and much less than the equivalent local yield, which is around 0.55% for Bunds.  For US investors, the situation is inversed, as they are getting paid to hedge their EUR exposure. As such, a US investor can earn about 3.85% by buying a 10-year Bund and hedging it. The high cost of hedging USD exposure could explain why the USD has failed to appreciate more, considering the very positive interest rate differential in its favour.

 

Fig 1.JPG

Source: Bloomberg

 

What is driving the high cost of hedging?

The current situation, where the cost of hedging completely eliminates the yield advantage of an asset, is very unusual and is driven by the following factors:

  1. Rate differential. The cost of hedging is a direct function of the yield differential between two countries. As such, since most investors would use 3-month FX forwards to hedge their foreign exposure, the cost of such instruments are directly linked to the 3-month rate differential. In the current context, where the Fed is well ahead of other central banks in its tightening cycle, it is normal for the cost of hedging USD exposure to be high.

  2. Shape of the US yield curve. The shape of the yield curve will also influence determine whether an investor would have an inventive to take advantage of the rate differential. A flatter curve, as we have currently, means that there is little difference between the short-term yield differential and the long-term one, leaving very little in the way of yield once the cost of hedging is applied

  3. Cross currency basis. A cross-currency basis swap is a floating/floating swap where two parties borrow from – and simultaneously lend to – each other an equivalent amount of money denominated in two different currencies for a predefined period of time. The basis refers to a premium or discount that is added to the swap, which will fluctuate with the supply and demand of the various currency. 

Currently, there is excess demand for USD meaning investors need to pay a premium in order to access USD in the swap market. This is currently around 40bp on a 3-month period2. In our view, this premium has increased in recent weeks due to three factors: 

  1. USD are often in high demand in the fourth quarter, as many corporations borrow short-term USD to improve their balance sheet for the end of the year. This has been the case over the past three years. 

  2. Increased tensions in Europe, resulting from the Italian budget, have also increased demand for protection via the swap market. This was also the case during the European crisis in 2012, when the basis reached record high levels. However, the situation is not nearly as tense as it was in 2012. 

  3. It is possible that the repatriation of foreign earnings by US corporations may have reduced the supply of USD outside of the US markets.  

Our view is that the current situation could deteriorate further and the premium for USD is likely to remain elevated at least until the end of the year, after which we should expect some normalisation i.e.: a reduction in the premium to access USD.

 

Fig 2.JPG

Note: a negative number means that there is a premium for the USD. 

Source: Bloomberg

 

Any relief in sight?

The hedging cost is mainly being driven by the short-term interest rate differential and it is unlikely it will ease in the coming months. The Federal Reserve is expected to continue to normalise its policy, likely increasing its policy rate by about 100bp over the next year, while the European Central Bank (ECB) is expected to leave its policy rate unchanged until the end of summer 2019.

There is a potential chance that the yield curve could steepen somewhat in the coming months. We have seen recently the yields on 10yr UST increase by more than the short-term yields. This movement came in reaction to better-than-expected data in the US and some other factors that justified upside pressures in US yields:

  1. Fed turning from a net buyer of treasury to a net seller

  2. Increased issuances as a result of a bigger budget deficit

  3. Reduced foreign demand for UST due to excessive hedging cost

  4. Reduced buying by pension funds as a tax incentive lapsed.

However, while a steeper curve would help make US assets more attractive, we think it would only be a small relief, as the curve is unlikely to steepen meaningfully, unless there are signs that the long-term real neutral rate has increased. We believe there will be a limit to how much the curve can steepen this late in the cycle. One possible source of upside pressure on long-term yields could come in the form of a normalisation of the term premium, as the Fed reduces the size of its balance sheet (see here for a discussion on the impact of QE on long-term US Treasuries) and some possible increase in inflation expectations, as inflationary pressures continue to build.

 

What can investors do?

Investors in low-yielding countries are eyeing the higher US yields with envy. However, the high hedging cost discourages them from taking advantage of the discrepancy. As a result, investors are exploring ways to improve their returns.

Unfortunately for those investors, there are no easy solutions to their problem. To improve returns on USD-denominated assets, investors will either need to accept extra risks or a different form of risk:

  1. Reducing their hedging ratio. This would reduce the cost of hedging, but at the cost of increasing the currency risk. Moreover, to be successful, an investor needs to have a view on the evolution of the exchange rate, as they would suffer a loss if the foreign currency depreciates.

Our view on the USD is that it is likely to remain strong in the coming months, as the positive rate and growth differential continue to provide support for the greenback. However, in the medium term, we believe that the USD is likely to depreciate, as other central banks start their monetary tightening and the pressures from a worsening fiscal situation start to be felt. The USD close to a historic high and, based on the real effective exchange rate and amid signs that investors are already quite long USD, the balance of risk is tilted to the downside.

With these considerations in mind, it would prove risky to reduce the hedging ratio. The losses incurred as a result of any depreciation in USD would likely outweigh any yield gains that stemmed from the reduction in the hedging cost.

 

  1. Going down in credit risk. Investors may also consider going down in terms of credit risk, e.g. buying agencies or corporate bonds to improve the yield. However, this also changes the risk profile of the investment by increasing the credit risk, while leaving the currency risk unchanged. The yield on A-rated US corporate bonds is currently higher than UST by about 4.10%3. However, once hedged, the yield remains lower than on equivalent EUR-denominated corporate bonds and marginally higher than the yields on a German Bunds, but with higher risk. Hence, providing little incentive for a European investor.

Whatever solution investors decide to choose to improve their yield on their hedged USD assets, there is no free lunch and they all imply an increase in the overall level of risk of their investment.

 

1 Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.
2 Source: Bloomberg.
3 Source: Bloomberg.

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