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Hedge Problem: US Bonds Aren’t As Attractive As They Seem

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One of the reasons Main Street got blindsided in 2008 was Wall Street’s penchant for obfuscation. When you, as a retail investor, hear something like “collateralized debt obligation,” you have a very understandable tendency to tune out. It’s like Stephen Colbert once famously said: “You’re-a-bore is what someone says when you mention EURIBOR.”

But the thing you need to understand is that these supposedly esoteric, complex concepts and instruments are actually far simpler to understand that your average corporate balance sheet (especially in this era of non-GAAP crap):


(Chart: Morgan Stanley)

Some of the more interesting commentary we read today came (characteristically) from Bloomberg’s Richard Breslow. Here’s an excerpt:

“But whether it was the ECB waiting, Fed speakers pressing or, more likely, 30-year JGBs “backing up” to 50bps, global bonds decided some caution was in order. And in the world of extraordinary monetary “largesse,” bonds are the global investing bellwether. Everything else follows their lead. Lo and behold, we learn that Japanese investors last week were sellers of foreign bonds — in size. Turns out that with swap rates such as they are, U.S. yields just aren’t as attractive as they look at first blush.

So that’s important. It sounds complicated but it’s not. Think about it. You’re literally paying Tokyo to loan them money (negative yields on JGBs), so why not just buy US Treasurys which, while the yields are admittedly paltry, at least they are above zero. Well, that makes sense, but you want to currency hedge your position right? Because who knows what USDJPY is going to do going forward. Well, as we’ve documented elsewhere, the global dollar funding crunch has actually driven up the cost of FX hedging to the point where the trade is no longer worth it. Have a look:


(Chart: Deutsche Bank)

That’s actually an extremely important chart. Basically, Japanese investors can no longer pick up any yield versus Japanese govies thanks to the rising cost of hedging the USD. Why should you care? Well because what that means is they’ll have to do one of two things: 1) take more duration risk, or 2) move down the quality ladder.

Pay attention to these dynamics, because these are the kinds of supposedly “obscure” things that drive flows.


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