Since the beginning of the year, 10-year US Treasury yields rose by more than 70 basis points. European sovereigns followed, but the rise in yields was contained thanks to the intervention of the ECB's increased purchases under the Pandemic Emergency Purchase Programme (PEPP). Yet, the threat coming from higher yields in the United States is not totally removed. If inflation expectations rise substantially, we can expect US yields to continue to increase, dragging European sovereigns with them. Although the Federal Reserve might accept higher yields as the economy recovers, this is something that the ECB wants to avoid at all costs.
Still, the ECB is fighting an uphill battle because it is left alone to stimulate the economy without fiscal stimulus. At the same time, US Treasuries begin to offer an appealing alternative for yield-starved foreign investors, posing European sovereigns to rotation risk. Indeed, once hedged fully against the EUR, US Treasuries with 10-year maturity provide a yield of -0.18%, approximately 13 basis points over the Bund. However, the situation gets even more alarming when looking at the periphery.
Portugal pays around 0.23% for 10-year government bonds, 41 basis points over fully FX hedged US Treasuries. However, in light of capital requirements, it is more expensive for banks to hold Portuguese debt than US Treasuries, eroding this differential further.
It is worth considering that not all investors hedge their FX risk because income opportunities are scarce, with about 35% of all non-US debt providing a negative yield. In this environment, not hedging at all looks like a risk worth taking to maximize returns. Research from Morgan Stanley shows that ideally, it is never good to hedge a position fully against FX risk. For EU investors, the optimal hedging ratio is around 66% of the amount invested, while it's 80% for Japanese investors.To better understand investors' benefits to buy into US Treasuries versus European peers, it's helpful to consider another hedging strategy involving three months rolling forwards. In that case, yield erosion would be sensibly lower, and 10-year US Treasuries would provide a yield of around 0.92%, seven basis points over 10-year Greek government bonds.