Confidence in the U.S. Treasury market takes a hit globally

Jon Sindreu, market and economics columnist at the Wall Street Journal, said foreign investors have plenty of reasons to be wary of U.S. government debt at the moment. He believes they can often receive better returns buying bonds in their own countries.

The economist noted that the risk of a weaker U.S. dollar and the cost of protecting that risk are making American assets less attractive worldwide. According to him, the shift from those assets also comes as the U.S. Treasury market is already contending with a darkening U.S. budget picture and trade war.

Investors seem concerned by U.S. market uncertainty

Sindreu believes that foreign investors are concerned because the premium many once received for buying U.S. debt has disappeared due to higher long-term rates in the U.S. He acknowledged that the circumstance has resulted from the rising cost of protecting against, or hedging, currency moves.

The economist said it’s happening because short-term rates have remained high in the U.S. relative to the rest of the world, and the Federal Reserve looks less likely to cut them anytime soon. Official data showed foreign Treasury holdings still surged in March, with similar government-bond sell-offs occurring in Germany, Britain, and Japan.

The market columnist noted that the market’s negative response to President Trump’s tariffs and Republicans’ tax-and-spending package has often coincided with a falling dollar. He believes it could signal capital flight since foreign investors hold about one-quarter of the Treasury market and lend significantly to U.S. corporations.

He also said that key financiers of American debt might not withdraw but will likely demand compensation for the currency risk associated with the recent fall in the greenback.

Sindreu explained that institutional investors must hedge foreign-currency assets or face potential losses from exchange-rate moves. He said it’s why major U.S. debt buyers in the eurozone and Japan don’t find 10-year Treasury bonds of around 4.5% attractive, even if their own government bonds offer just 2.5% and 1.5%, respectively.

The economist noted that British investors switching from UK government bonds to Treasurys receive no premium after hedging. Eurozone investors face a post-hedge yield difference of minus 0.6 percentage points compared with Germany’s 10-year government bonds and even worse versus other European bonds.

Fed’s increased rate hike hedging costs 

According to Sindreu, Japanese investors face an even less appealing trade-off since they now receive a hedged 10-year yield 1.3 percentage points below domestic alternatives despite being top foreign holders of Treasurys. He said it is smaller compared to that of 2022 and 2023, when the Federal Reserve raised rates to combat inflation while the Bank of Japan held firm on stimulus.

The market columnist argued that the rise in hedging costs, driven by the Fed’s pushing up short-term rates much deeper, hindered Japanese banks, pension funds, and insurers from purchasing more U.S. debt. The International Monetary Fund showed that Japan later dumped $331 billion of U.S. debt instead, yet it was almost a matter of time until the Fed paused rates. He noted that banks started buying debt again as hedging costs eased.

Sindreu said the problem was that Trump’s tariffs have turned the tables again, where the Fed could cut rates at a slower pace if the levies stoked inflation. He noted that the anticipation of cuts has led to a flatter yield curve in the U.S., while it steepens in the eurozone, Britain, and Japan.

The economist argued that it mattered for currency-hedged returns, where investors hedge long-term bonds using short-term derivatives, making it an implicit bet on the relative shape of yield curves. He acknowledged that the only path to profit from higher U.S. yields is by buying bonds unhedged.

Sindreu said that banks are unlikely to do that due to risk exposures, but pension funds and insurers might. Japan’s Government Pension Investment Fund has held almost all foreign bonds unhedged. The Bank of Japan also reported last October that the nation’s insurers reduced their hedge ratios from 60% in 2021 to closer to 40% in 2023.

He noted that European pension funds don’t hedge, but they did while riding dollar gains of 31%, 17%, and 12% against the yen, euro, and pound, respectively, between early 2021 and mid-2022.

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