With the US Federal Reserve’s (Fed’s) interest-rate-hiking cycle now underway, it’s an important time to keep a close eye on non-US buyers of US dollar (USD) fixed income securities. Historically, Japanese and European investors have been large participants in the space. But if the Fed continues to raise US rates as expected, the positive carry return1 that these investors have recently reaped from US Treasuries may turn negative because the Fed’s rate hikes will increase the cost of foreign-exchange hedging for non-US investors, particularly in Japan. Indeed, taking account of currency hedging, European fixed income could start to look more attractive than its US counterpart to Japanese buyers.

Figure 1 shows the spread of hedged 10-year US Treasuries versus 10-year Japanese government bonds (JGBs) in light blue and the spread of hedged 10-year German bunds versus 10-year JGBs in dark blue. Both lines use a 12-month currency forward, instead of the more commonly used three-month forward, to better incorporate the potential effects of the widely anticipated US rate hikes in the period ahead.

But, one might ask, wouldn’t additional Japanese flows into Europe then drive more European flows into potentially higher-yielding USD markets? Not necessarily. Notably, Germany has begun to move away from its traditionally austere budget views. Meanwhile, the European Central Bank is pivoting (albeit slowly) toward a more hawkish policy stance, with European interest rates having moved up substantially this year. Bund yields have already entered positive territory (as of this writing). We’ve even heard rumblings about possibly ending negative deposit rates in the eurozone at some point this year.

This is a very different environment from Japan, where the Bank of Japan has thus far generally been holding the line on negative rates and yield-curve control.

¹Positive carry is an investment strategy that involves investing borrowed money and then earning a profit on the difference between the return and the interest owed. Investors commonly use positive carry in currency markets.