The Treasury Market Could Soon Get More Love
While markets are jittery about U.S. government bonds, foreign investors now have a big incentive to buy them with currency hedges
By Jon Sindreu
Like beauty, the value of a financial asset is in the eye of the beholder.
Right now, Treasurys look much better from outside of the U.S.
On Wednesday, the U.S. placed $38 billion worth of 10-year debt at a closely watched Treasury auction.
These are usually prosaic events, but record-low demand at the seven-year auction last month—particularly from foreign buyers—acted as a “sell” signal in a market already under pressure: 10-year yields recently rose above 1.6%, from 0.9% at the start of the year, denting stocks in the process.
In the end, investors put in a decent showing at the March auction, with a 2.38 bid-to-cover ratio and 20% of foreign bidders, in line with recent history.
Yields have now retreated below 1.5%.
A key driver of the bond selloff has been expectations of a rebound in economic growth, combined with hints from the Federal Reserve that it isn’t bothered if good news leads investors to anticipate slightly higher interest rates.
But Fed data also indicates that factors other than rate expectations are contributing to the increase in yields, prompting deeper worries.
Some fear, without justification, that the government will get punished for committing vast fiscal resources to fighting the pandemic.
Others are concerned that disruptions in market plumbing have amplified the rout, as a result of regulations that impose costs on banks for acting as middlemen.
When rates are expected to increase by a very uncertain amount, few investors want bonds.
Currently, speculators are paying to borrow Treasurys and bet against them.
Wednesday’s auction is a reminder that, in the most liquid market in the world, buyers do turn up.
Overseas demand for Treasurys, in particular, could strengthen.
Investors in the eurozone and Japan are getting negative returns of 0.3% and 0.1%, respectively, for buying their own ultrasafe 10-year government bonds.
Even after the cost of currency hedging, the 1.5% available on a U.S. bond gives them a full percentage point more yield than their domestic bonds—the most in four years.
This is a recent phenomenon: For most of 2020 it was U.S. investors who got paid extra for investing in the eurozone and, for a brief period, even in Japan.
In theory, this trade should already have been arbitraged away.
One reason it hasn’t is that the bank balance-sheet constraints that have affected Treasury liquidity also have an impact on hedging costs.
The other is that investors usually protect their bond purchases by rolling over three-month currency hedges.
Since the cost of these hedges is tied to the yield on three-month bills, which haven’t sold off as much as 10-year bonds, foreign buyers gain whenever the Treasury yield curve steepens.
Once the dust settles on recent market gyrations, many overseas bond buyers will find an extra percentage point of yield too juicy to pass up.
Unlike U.S.-based investors, which are still selling the mammoth $24 billion they put into Treasury funds in the first half of 2020, foreign investors may have room to grow their holdings, data from fund-flow tracker EPFR Global suggests.
U.S. investors are selling Treasurys bought because of Covid.
Foreigners have head room to buy more.
The past year’s volatility has shown that even the Treasury market is vulnerable to hiccups, leading some investors to call it “broken.”
Its role as a global haven, though, isn’t going away.
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