(Bloomberg) -- Rising currency hedging costs and a surge in short-term U.S. bond yields are driving Japan’s money managers away from Treasuries and making them more inclined to buy debt in Europe.
Japanese investors’ appetite for debt offered by countries such as France and Germany is expected to increase, with a booming European economy -- the region’s central bank estimates the fastest expansion in 10 years in 2017 -- adding to the allure. At the same time, dollar-yen hedging costs, calculated using currency forwards, are near the highest level since the 2008 global financial crisis.
“There is no doubt the attractiveness of U.S. bonds is fading,” said Kensuke Niihara, Tokyo-based head of investment solutions group and currency at State Street Global Advisors, which oversaw $2.6 trillion globally as of end-Sept. "Considering the short- and long-term bond yield differentials, which is very important for Japanese investors, countries like the U.K. and France would look attractive, especially France."
The U.S. curve has been flattening, with the two-year yield having surged about 70 basis points since the end of August. The 10-year yield is up 43 basis points in the period. The U.S. dollar has had a shaky start to 2018, and fell to a four-month low against the yen this week.
It currently costs 2.05 percent to hedge three-month positions for the dollar-yen, compared with last year’s low of 1.41 percent in February. In comparison, the cost to hedge similar euro-yen positions has fallen below zero, indicating Japanese investors can pick up extra returns on top of yields.
Europe bonds will be attractive for investors who hedge their currency exposures as hedging costs have risen in the U.S., said Eiichiro Miura, general manager of the fixed income investment department in Tokyo at Nissay Asset Management Corp.
‘Very Convincing’
While the Federal Reserve plans to raise interest rates three times this year, investors are finding that it may be more profitable to hold other currencies than the dollar. The European Central Bank is sounding more hawkish than expected, and some money managers are betting that the Bank of Japan may be near to adjusting its policy in the months to come.
"The economic outlook of Europe looks very convincing," said Masayuki Kichikawa, chief macro strategist of Sumitomo Mitsui Asset Management Co.’s economic research department. "Some political risks remain but low hedge costs and solid economic conditions will prompt Japanese investors to direct their funds into countries that offer higher yields."
Some of that is happening already. Japanese investors were net buyers of French sovereign bonds for a third straight month in November, data from the Ministry of Finance showed last week. They also purchased German debt for a second straight month, while selling U.S. securities.
Some investors from Japan have also been buying Swedish krona-denominated bonds since last year, said Hideaki Kuriki, chief fund manager at Sumitomo Mitsui Trust Asset Management Co. Investors, including financial institutions, are interested in putting money into bonds of countries carrying high credit ratings such as the U.K., France and Sweden, he said.
They are reluctant to invest in Spain and Italy despite relatively higher yields, because of the credit risks involved, he said.
Japanese investors could continue to seek “more opportunity” in European countries that “offer a premium when they hedge their currency exposures,” Kuriki said.