Treasury Yields Face Curbs From Fistful of Money-Market Dollars

(Bloomberg) -- The flood of dollars that’s helping to drive some U.S. money-market rates below zero could well provide a boost to international appetite for longer-dated Treasuries and help to cap rising bond yields at the longer end of the curve.

The abundance of greenbacks in funding markets -- which is being fueled by a combination of Federal Reserve monetary policy and the prospect of government spending around the $1.9 trillion U.S. stimulus package -- has helped drag down the cost for non-dollar-based investors of hedging the currency risk on their holdings of Treasuries. That, combined with now higher nominal yields in America, means that it is looking more attractive for those investors to step in and buy.

“The hedged yield has not been so attractive in euro and yen for years,” said Chris Iggo, chief investment officer at AXA Investment Managers.

For managers of euro and yen portfolios that buy dollar-denominated asset and hedge the currency risk on a three-month basis, the shift in so-called cross-currency basis swaps since last year along with the outright climb in nominal yields, means that the yield on benchmark U.S. 10-year notes is now around the highest since 2017, and well above what they can get in their home markets. That could see foreigners stepping in to buy in the wake of the bond selloff last week that send 10-year yields spiking above 1.6%, although whether that can halt the drive toward ever higher Treasury yields remains to be seen.

“The recent rise in U.S. yields and developments in cross-currency basis has increased the attractiveness of U.S. Treasuries for international investors,” said Mohit Kumar, strategist at Jefferies International.

Euro-based investors buying 10-year Treasuries can pick up 113 basis points over 10-year German bunds. Meanwhile, yen-based investors who typically measure the 10-year Treasury versus 30-year Japanese government bonds, will get a yield pick-up of 47 basis points on that trade, according to Kumar, a former trader.

Three-month cross-currency basis swaps for the yen and euro have slipped from highs seen in this year, but are still well off lows reached in December. The Fed’s efforts to boost dollar liquidity and the U.S. Treasury’s bill supply cuts have led to an abundance of dollars available in the money-market system. The glut of dollars is keeping overnight investment rates near zero, with slightly negative rates also appearing from time to time for loans collateralized by Treasury securities.

The three-month yen cross-currency basis swap was at minus 11.25 basis points Tuesday. A Japanese investor looking to hedge Treasury exposure would borrow in yen, paying the three-month local Japanese Libor (currently minus 0.087%), and convert the yen to U.S. dollars in order to buy U.S. Treasuries. The Treasuries can be sold via reverse repo and the proceeds converted back to yen via the cross-currency basis swap.

There’s speculation that Japanese investors will become more involved in the trade after the start of the fiscal year in April.

Curve Steepening

U.S. yields soared last week, with the 10- and 30-year tenors reaching the highest levels in more than a year, pricing in an economic recovery as the U.S. virus infection rate eased amid the vaccine rollout. The 10-year yield rose as high as 1.609% while the 30-year touched 2.394%. The market has since stabilized, with the 10-year easing back to around 1.42% on Tuesday.

“I would be surprised to see 10-year yields rising above 1.5% on a sustained basis, let alone 2%,” said Nikolaos Panigirtzoglou, strategist at JPMorgan Chase & Co. “At 1.5% we are likely to start seeing pension fund flows, yen-based and euro-based investor flows into Treasuries,” provided that rate volatility subsides.

“It’s not possible here to have a sustained de-coupling of the curve steepening in the U.S. vs other regions,” said Panigirtzoglou. “If the U.S. curve keeps steepening, investors outside the U.S. will eventually exploit the yield advantage.”

Core euro-zone and Japanese yields have failed to break out of the ultra-low ranges that have prevailed in recent years. Japan’s 10-year yield is still below 0.20% while Germany’s is negative 0.35%.

“With the Bank of Japan still committed to yield-curve control and the European economic outlook not justifying higher yields, foreign investors are very likely to take advantage of this opportunity,” AXA’s Iggo said.

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