Submitted by Taps Coogan on the 5th of August 2019 to The Sounding Line.

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The best explanation of the mechanics of currency-hedged fixed income investments that I have come across is this article, by Concentrated Ambiguity. The punchline is that the effective yield on currency hedged investments has more to do with term premia, i.e. the shape of the yield curve in a target country, than the interest rate differential between two countries.

Imagine a Japanese investor who prefers to invest in long-term US Treasuries yielding somewhere around 2% instead of the equivalent Japanese Government Bonds that yield a negative value. By the time the Japanese investor accounts for the cost of currency hedging the trade, they are really getting the difference between short term US rates and long term US rates, not the difference between Japanese rates and US rates. Again, read this article by Concentrated Ambiguity for a detailed explanation.

Why is this important? When the US yield curve becomes flat or inverted, it ceases to be profitable for foreign investors to purchase currency hedged US treasury debt, regardless of how much higher US rates are.

Today, the US Treasury yield curve is deeply inverted and currency hedged treasury rates have become negative. Accordingly, the multi-year decline in foreign holdings of US treasuries has been accelerating.

When the yield curve inverts and effective yields for foreign investors become negative, global capital flows start freezing up. This happens at the same time that fixed income investors are already expressing their belief, via the yield curve, that short term rates are too high relative to long term growth prospects. Simultaneously, banks see their profit margins squeezed because they borrow in short term markets and lend in long terms markets. Add it all up and it should not come as a surprise that yield curve inversions have almost always been followed by a recession within a couple years.

There are some compelling arguments that today’s inverted yield curve is more of a reflection of very low rates oversees than a reflection of expectations for low growth in the US. While that may be true, it is of little comfort. Whatever is causing the inverted yield curve, it is in-and-of-itself a threat to financial markets. Unfortunately, the Fed’s recent rate cut actually made the yield curve more inverted as long term rates fell even faster than short term rates. That should have investors particularly worried, as it’s increasingly unclear what, if anything, will un-invert the yield curve in the near term.

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