Should European Fixed-Income Investors Take More US Currency Risk?

10 September 2019

3 min read

With euro-area bond yields hitting new lows, higher yields in US fixed income look increasingly tempting. But high hedging costs and a weak euro are enticing investors to leave US dollar exposure unhedged. In today’s environment, we think that’s a high-stakes gamble.

As growth forecasts have reduced across the eurozone, European bond yields have tumbled. The euro-area AAA government bond yield curve is now completely negative out to 30 years maturity, while the yield on the Bloomberg Barclays Euro Aggregate Bond Index is close to zero*. In this challenging environment, income investors are inevitably looking further afield for worthwhile yields.

While US bond yields may appear to be attractive, the cost of hedging US currency risk effectively wipes out their extra yield. Currently that cost is approaching 3%—leaving euro-area investors with negative yields on virtually any US investment-grade asset, net of hedging expenses.**

Meanwhile, the euro shows no sign of strengthening. Weak growth in the eurozone, combined with a new round of European Central Bank (ECB) asset purchases and the risk of a no-deal Brexit are all holding the euro back. So why hedge a currency risk that seems remote, when the rewards from unhedged US bond exposure look so juicy? How likely is it that currency fluctuations could wipe out a 3% yield from high-quality US bonds?

Unhedged Exposure Is Much More Volatile

Leaving currency unhedged adds volatility to an allocation. For example, the unhedged returns of the US Aggregate Bond Index are over three times riskier than the hedged returns (Display). In fact, the return pattern from the unhedged index behaves more like an equity investment than a bond investment. From a portfolio construction perspective, the heightened volatility of the unhedged return stream undermines the normal function of fixed income as a portfolio anchor.

Leaving Currency Exposure Unhedged Dramatically Changes the Risk Profile

Bloomberg Barclays US Aggregate Index Euro Hedged and Unhedged Performance: Rolling 12 Months

Past performance and current analyses do not guarantee future results.
As of August 30, 2019
Source: Bloomberg and AllianceBernstein (AB)

Macro Background Adds to Risks

Today, there are additional risks to unhedged currency exposure. In particular, US dollar currency risk could be aggravated by political uncertainty, trade wars and monetary policies.

The US dollar exchange rate is a hot political topic ahead of US presidential elections in November 2020. The US administration is naturally sensitive to factors that are material to the economy including an overvalued dollar. In fact, the US productivity-adjusted real effective exchange rate (REER) is near peak levels on a 30-year view, and over 40% higher than the trough of the early 1990s (Display). As the health of the US economy will be a key issue in the election campaigns, President Trump will be keen to see both lower rates and a more competitive currency, in our view.

US Dollar Productivity-Adjusted Real Effective Exchange Rate (REER)

The Dollar Is Riding High Against Global Currencies

Past performance and current analyses do not guarantee future results.
Productivity adjustment calculation based on the Harrod-Balassa-Samuelson effect
As of 1993 through June 2019
Source: AllianceBernstein (AB)

Europe’s—and in particular Germany’s—large trade surplus has long been a bone of contention with the US. Now that the ECB has signalled a renewal of monetary stimulus and European government bond yields have fallen further, the US has the single highest interest rate in the developed world. That further erodes US competitiveness, creating an additional handicap for the US economy.

Against this backdrop, US/Europe trade tensions could flare up again. For some time, the imposition of US tariffs on European goods has been a possibility. Now, in our view, currency intervention by the US is very much on the table. Presidential advisors have publicly indicated that it’s been a discussion point in the White House. Currency intervention is rare because it’s not usually very effective. But this decision is at the president’s highly unpredictable discretion.

Bearing all these factors in mind, does it really make sense to leave US dollar exposure unhedged? An unhedged exposure could be very volatile. Investors who take the risk should be ready for a bumpy ride.
*Bloomberg Barclays Euro Aggregate Bond Index yield was –0.08% as of September 9th, 2019

**Based on EURUSD hedging cost of 2.71% as of September 9th, 2019

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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