Stronger U.S. data, additional fiscal stimulus and an acceleration in vaccination efforts have prompted a significant repricing of U.S. interest rate expectations. The U.S. yield curve has steepened considerably. Since the beginning of the year, 10-year Treasury yields have risen by 65 bps and the 10 – 2 curve has steepened by 63 bps.
Conditions have improved in the Eurozone, too, but at a slower pace. Protracted lockdowns have weighed on economic activity for an extended period and the vaccination process has suffered delays, in part due to early supply problems. Consequently, the core European curves have experienced a much more contained rise in yields.
Caution on duration is still appropriate, but as we approach the 1.50 – 1.75% range on 10-years, we expect a more balanced two-way market. The rapid U.S. curve adjustment could attract the attention of euro-based investors looking for opportunities on a hedged basis. Therefore, a potential reason for consolidation could well be the emerging foreign demand from Europe and Japan.
Let’s look at the numbers from the perspective of euro-based investors:
Currently in the U.S., 10-year yields are approximately 1.55%, while, in Europe, Bunds trade approximately -0.30%, for a spread of 185 bps. Currently, our estimates of FX hedging cost is very low relative to history, at about 0.82%.
Therefore, a euro-based investor buying 10-year Treasury bonds could pick up 103 bps over the yield of 10-year Bunds by implementing this currency hedge. This represents a meaningful change from a couple of years ago. In January 2019, 10-year Treasury bonds hedged back to euros would have yielded 80 bps below the 10-year Bund. The reason for this big swing is simple. Back then, the cost of hedging back to euros was extremely high, over 3.2%.
Since 2002, the euro-hedged spread between 10-year U.S. Treasuries and 10-year Bunds has been within +/- 100 bps about 82% of the time, suggesting that strong mean-reversion forces emerge at the extremes.¹
The conditions are similar for Japan-based investors. Buying 10-year Treasury bonds hedged back to yen could result in about 96 bps over the yield of 10-year Japanese government bonds.
In summary, even if we believe that 10-year Treasuries could end the year above current levels, investors should keep an eye on rising foreign demand that has the potential to help stabilize the U.S. bond market.