Buying Dollars Gets Pricey
A rising price for dollars borrowed overseas underscores the crosscurrents roiling trading
By BEN EISEN
March 18, 2016 9:15 p.m. ET
A scramble for U.S. dollars is rippling through global markets, driving up the costs that foreign companies and financial institutions pay to hedge against currency swings.
Japanese firms borrowing dollars for five years have been paying a premium of as much as 1.05 percentage points annually over going interest rates, the most on records going back to 2008, according to Thomson Reuters data on cross-currency basis swaps, a derivative widely used to hedge foreign-exchange risk. Firms in Europe are paying as much as 0.58 percentage point this month, a level last seen in 2012.
A rising price for dollars borrowed overseas underscores the crosscurrents roiling trading at a time of divergent central-bank policies and an epic commodity bust. The WSJ Dollar Index is down 3.6% this year, but many analysts and investors expect it to appreciate as much as 15% during the Federal Reserve’s efforts to raise U.S. short-term interest rates.
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Dollar strength has emerged over the past year as a major risk factor for the global economy. Gains in the U.S. currency stand to intensify market volatility by further weakening global commodity producers and hampering Fed efforts to push consumer-price inflation closer to its 2% annual target.
“It’s been extremely important for the stock market and bond markets,” said David Donabedian, chief investment officer of Atlantic Trust Private Wealth Management which had $27 billion in assets last month. “I think over the course of the year we will probably move toward a stronger dollar environment.”
In a cross-currency basis swap, trading partners—typically financial institutions acting on behalf of clients or for their own purposes—agree to exchange the periodic payments attached to certain interest-rate instruments in different currencies. The difference between the rates each pays reflects the net cost of the swap to one party. The parties typically make this swap in a bid to reduce their exposure to large currency-value swings. Because the swap involves an exchange of cash flows, the demand for dollars is typically reflected in the additional cost to hedge, rather than the exchange rate.
Rising hedging costs already are starting to affect trading in developed-country government bonds, long the epicenter of financial markets, analysts said.
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Japanese investors such as pension funds and insurance companies have long been heavy buyers of safe debt issued around the globe, particularly U.S. Treasurys, typically hedging using basis swaps, said Dominic Konstam, head of rates research at Deutsche Bank AG.
But with hedging costs rising, Japan’s investors have been net sellers of $70 billion of Treasurys in the six months through December, the most on record, the bank said.
The same dynamic could come into play in Europe, analysts said, where the European Central Bank’s expanded use of negative rates is adding to downward pressure on global bond yields. “These negative interest rates push global investors into regions that they might not invest in,” said Jerome Schneider, head of Pacific Investment Management Co.’s short-term and funding desk.
More than $8 trillion in debt globally carries negative interest rates, according to a recent estimate from J.P. Morgan Asset Management.
The tussle for dollars is coming at a crucial time for investors. Demand is growing among those trying to take advantage of higher bond yields in the U.S. while supply is shrinking because the Treasury needs to borrow less money to fund a shrinking trade deficit with the rest of the world. The current-account deficit was 2.7% of gross domestic product in 2015, up from 2014 but down sharply from the financial crisis.
“The supply of dollars in the world is going down and probably continues to remain tight until the current-account deficit increases meaningfully,” said Krishna Memani, chief investment officer at OppenheimerFunds Inc.
While currency hedging doesn’t necessarily affect the value of the dollar against its rivals, it is an underappreciated factor in the large gaps in rich-country government-bond yields, analysts said.
On Friday, the 10-year U.S. Treasury yielded 1.87%, compared with 0.21% in Germany and minus-0.1% in Japan. But “if you look at the current levels when you do FX conversion, Treasury bonds look expensive compared” to those sold by peers, said Jonathan Rick, an interest-rate derivatives strategist at Crédit Agricole.
The Fed held U.S. rates steady on Wednesday but said it could raise the federal-funds rate at future meetings if consumer prices keep rising and the labor market continues to improve. The Bank of Japan instituted negative interest rates in January, and the European Central Bank pulled its rates further negative last week.
The dollar appreciated significantly against the euro and yen in recent years, as the divergence trade became popular on Wall Street, but this year it is down 3.6% against the euro and 7.3% against the yen.
Goldman Sachs Group Inc. analysts on Wednesday said the dollar could rise another 10% to 15%. Deutsche Bank AG said the dollar should continue strengthening as the U.S. unemployment rate keeps falling.
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