‘We’re Caught in a trap, I can’t walk out’
Most of us love a conspiracy theory, due to our suspicious minds, and it appears to us the ECB are at the moment setting a trap for European investors. There has been a lot of discussion in Euroland, especially Germany, regarding the relatively high cost of hedging US dollar currency exposure back to euros. At the time of writing the three month hedge cost calculates out to an annualised 2.8% and with 10-year UST yielding just 2.9%, the obvious trade for European investors is to buy Bunds at 0.375%.
However, that ignores the real rates of return in either market. Although in the short term real rates can be ignored, over time this factor needs consideration. The real rate on UST is around +0.80% while the Bund is -1.32%. The trap that has emerged is that the ECB by keeping short rates in negative territory are not only utilising the hedge cost to keep European rates lower by creating massive home grown demand for domestic bonds but are also funding the various governments’ finance requirements and thereby helping to stimulate the European economy.
So what happens when the market realises that the ECB could be closer to tightening than first perceived? 10-year Bunds yielded 0.65% back in May before the latest Italian episode, a return to that level equates to a 2.5 point loss in price and if you want a real yield equivalent to the UST 10-year at euro inflation of 1.7% + 0.8% that would push the Bund yield to 2.5%; a fall from today’s price of 18 points. Now maybe that’s a bit extreme, so a move on the Bund to just 1.25%, half of that move, is a loss of 8 points in price.
The equivalent 8 point move in the UST market would push the 10-year yield up to 3.85% and if we see that level, the world economy is rocking and under that scenario we could see an 18 point loss on the Bund.
So whilst the hedge cost is indeed a burden to European investors, the risk adjusted trade is to pay the hedge cost and avoid the likely ratcheting up in European rates that has to come sooner or later.
How to avoid the trap, buy into a portfolio of high quality Eurodollar bonds at yields of UST plus 190bps thereby reducing the hedge cost down to a reasonable level whilst avoiding the risks applicable to European interest rate curves.
‘Caught in a trap’, just open the door.