Alessandro Marolda, senior consultant of the Portfolio Research & Consulting Group at Natixis Investment Managers, looks at the growing cost of hedging for sterling and euro-based investors buying US dollar-denominated assets.
One of the biggest asset allocation themes this year has been the large and growing cost of hedging for European investors buying US dollar-denominated assets. This has affected mainly EUR-based investors but the burden on sterling investors is also starting to grow.
This is mainly due to the US Federal Reserve raising interest rates while European central banks have remained on hold. The larger the interest rate differential between two currencies the higher the cost of hedging.
For example, if interest rates in sterling are 0.5% and interest rates in US dollar are 2.0%, ceteris paribus the annualised cost of hedging the US dollar for a sterling investor will be 1.5% (2.0%-0.5%).
The majority of currency hedging occurs on the FX forward market, although some investors use other instruments such as futures and currency ETFs.
FX forwards (in addition to other financial instruments) are priced to take into account the interest rate differential, as well as a technical factor called the 'FX basis' - although this has generally speaking had less of an effect on pricing.
The green line is the 10-year Bund yield, the orange line is the 10-year US Treasury yield, and the red line the 10-year US Treasury yield hedged to euro. Despite the 10-year US Treasury yielding around 3% in US dollar terms, once hedged into euro the yield drops below that available on 10-year German Bunds.
This has created extra complexity for asset allocators in European regions.
Investors faced with very low interest rates locally were able to diversify into US assets, such as the US Treasury market, over the last few years (2013-16) and obtain higher yields without taking any foreign currency risk.
This is unfortunately no longer the case and European investors are, remarkably, better off investing in 10-year Bunds than US 10-year Treasuries hedged to euro from a yield perspective, despite yields on Bunds trading about 0.3%.
The other major factor contributing to this phenomenon has been the flattening of the yield curve in the US, whereby short-end rates have risen due to the Federal Reserve raising rates but the long end of the curve has not moved up significantly, as shown by the chart below, the US curve is now at its flattest since 2007.