Rising U.S. interest rates may well make investors think investing in U.S. bonds is a better choice at this time, but there are pros and cons to this approach.
Economic theory suggests that one country has higher interest rates than another because of differences in inflation rates and economic stability.
When one country has higher inflation than another (for example, Zimbabwe's inflation rate is almost 50% year-on-year), higher interest rates (Zimbabwe's 150%). Because there is a risk in lending money.
Nevertheless, when comparing the US and Europe, which have relatively similar inflation data, one wonders why the Federal Reserve's interest rate is currently 5.25% while the European Central Bank's rate is 4.5%. No wonder. See graph below.
While it is true that US inflation is typically higher than in the euro area (the most recent February CPI data for the US showed year-on-year inflation of 3.2% vs. 2.6% for the euro area), below The graph shows how inflation in the euro area has increased. The rate was 10.6% in October, compared to the peak of 9.1% in June. Meanwhile, the Fed's interest rates have always been higher than the ECB's. Therefore, it is difficult to explain differences in central bank interest rates using inflation as the only comparison.
The answer lies in the difference in economic power between the two countries. The graph below shows the US and European GDP growth rates over his four quarters of 2023. Obviously, the European economy was much weaker than the US economy. Furthermore, while US growth is increasing, growth in the euro area is moving in the opposite direction.
This has important consequences for central banks insofar as the US economy can accept higher interest rates than the euro area, thus creating a difference in interest rates.
US Treasuries vs. European Bonds: Which Should You Choose?
The big question for investors is whether there is a way to benefit from rising U.S. interest rates. This is true for any part of the interest rate curve (the interest rate curve is a graphical representation of the relationship between the yield or interest rate and maturity of a country's sovereign debt). Logically, you would be better off investing in a bond yielding 4.5% than investing in a bond yielding 3%. Please refer to the following.
In that case, it would be more interesting to invest in US bonds, which have higher yields, than Eurozone bonds. But in addition he has two considerations.
How does currency risk affect bonds?
True, U.S. bonds pay more interest than European bonds, but European investors have to take on dollar risk, which can be beneficial or harmful in some cases.
For example, if you compare two exchange traded funds that invest in the same part of the interest rate curve, iShares Euro Treasuries 1-3 Year ETF EUR and iShares $ Treasuries 1-3 Year ETF USD, one invests in the euro area and the other in the United States. It's one. When we compare performance over the past 12 months in euro terms, there are significant differences, as seen in the graph below.
How can I hedge dollar risk in fixed income investments?
If possible, hedging dollar risk is an option. Many dollar bond funds tend to have a euro-hedged class, meaning they are not assumed to be immune to currency fluctuations.
However, there is a cost to hedging dollar risk, and that cost is the difference in interest rates between the dollar and the euro, and high interest rates at least partially eliminate the supposed benefits of investing in the United States.
In fact, if you compare the performance of ETFs such as iShares Euro Government Bond 1-3 Year (European Government Bond ETF with maturities between 1 and 3 years) and iShares USD Government Bond 1-3 Year EURH (U.S. Government) over the past 12 months, , looking at currency-hedged bond ETFs with maturities between one and three years, European government bond ETFs delivered the best returns.
Why is a European bond ETF more profitable than a euro-hedged US bond ETF that invests in the same part of the curve? There may be small differences in the portfolio terms of these two ETFs, but they It's minimal.
However, even within the same part of the curve, there are differences in the evolution of interest rates between the United States and Europe. For example, the attached graph shows how his two-year bond rates on both sides of the Atlantic have changed over the past 12 months. They are not the same movement and therefore have different yields.
