Do Eurozone Yields Matter Anymore For Treasuries?

Remember when eurozone sovereign debt yields mattered to Treasuries? Back when the U.S. Treasury (UST) 10-year yield was hitting historic lows and any sell-off seemed to be capped, a common justification was that Treasuries still offered a relative yield advantage versus sovereign counterparts such as the 10-year German bund. Interestingly, during this year’s rise in the UST 10-year yield, this argument was conspicuously absent, raising the question: do eurozone yields matter anymore?

Europe’s Role in U.S. Markets

Over the last several years, the European Central Bank’s (ECB) bond purchase program has driven yields lower across Europe, which is clearly evidenced by the divergence between the U.S. and German 10-year yields. Since 2012, this spread has been on a steadily ascending trajectory, reaching an all-time high this year of +280 basis points (bps) in November. However, unlike the past few years’ experiences, this differential did not offer the same degree of support in capping the rise in the UST 10-year yield.

Let’s get some perspective on the whole “yield advantage” aspect of bond trading, as there is more to it than meets the eye. Consider an institutional pension fund or insurance company based in Europe. Thanks to their investment policy statements, many of these investors have required levels of quality investments in their investment portfolios, leaving them with only a handful of options from which to choose throughout the globe. Becuse these investors have gotten barely anything out of bunds, many have gone to U.S. Treasuries for their higher yields.

Of course, there is a hedging cost involved in this cross-Atlantic transaction, which is based on the difference between short-term interest rates in U.S. and Europe (just as U.S. investors are currently paid to hedge euro exposure, the opposite is true for European investors and the dollar). And because the Federal Reserve (Fed) is raising short-term rates at the same time the ECB is locked-in at negative rates, it is becoming more and more expensive for European investors to hedge U.S. dollar exposure when investing in U.S. securities.

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