Three major issues driving previous euro weakness have been fixed: following the resolution of the 2012 European sovereign debt crisis, the European Central Bank (ECB) has proven and diversified tools at its disposal; the period of negative interest rates is over and European yields are now at attractive levels relative to history; and the ECB is no longer constraining the supply of euro bonds through quantitative easing.
The depth and liquidity of the euro bond markets have also been issues in the past but have improved over time. In investment-grade corporate credit, for instance, the euro market is now over 40% the size of the USD market—plenty big enough to warrant a higher allocation for global investors.
A modest percentage reallocation out of USD bonds into euro fixed-income could have an outsize impact in price terms, in our analysis. For example, the German government bond (Bund) market is one-tenth the size of US Treasuries, so every dollar that moves out of Treasuries has a proportionately higher market impact on Bunds.
Two Ways to Capitalize: Hedged and Unhedged
The euro has risen by 11% against USD this year through August 12 (Display, left). For fixed-income investors expecting that trend to continue, an unhedged position in euro bonds may be compelling.
Alternatively, as we see it, a hedged approach may be beneficial for US dollar-based investors seeking exposure to euro bonds while avoiding currency-related volatility. Owing to the gap between short-term euro and USD rates (which has widened this year as the ECB continued to ease while the Fed paused), hedging their exposure to European bonds back to USD could enhance their yield by almost 2.5% (Display, right).
Global investors can capitalize on these dynamics by diversifying their allocation to US assets with European strategies (either hedged or unhedged, depending on their currency views).
