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Rising FX Hedging Costs now a U.S. Dollar Headwind

Foreign exchagne analysis

Image © Goroden Kkoff, Adobe Stock

- High cost of FX hedging in U.S. leading some investors away from Treasuries

- Could increase borrowing costs in the future and weigh on U.S. growth

- Phenomenon likely to be another headwind for the Dollar

The high cost of hedging FX positions in the U.S. is leading many foreign bond investors to ditch their U.S. treasuries and seek better returns overseas.

The trend is likely to continue for several years and could mean that the US government will find it increasingly difficult to attract financing from overseas.

This, in turn, could raise borrowing costs and eventually put a brake on US growth impacting negatively on the Dollar.

 

Higher Interest, Lower Gains?

The U.S. government pays higher interest to lenders for the money it borrows, compared to Europe or Japan - where interest rates are famously low - but the higher cost of hedging the Dollar eclipses the gain and actually means investors are better off lending to the German, Japanese or even Spanish government.

USD hedging table

Image courtesy of Bloomberg.

The implications of this quirk are that the U.S. may find it increasingly difficult to attract financing from abroad, and this could mean it has to raise interest rates to make loaning it money worthwhile for foreign investors.

"There’s never been a more profitable time for U.S. investors to ditch Treasuries and go abroad," says Katherine Greifeld, a correspondent at Bloomberg. "Those with Dollars to spare can lock in historically high returns in Europe and Japan, even though yields in the two markets are among the lowest in the developed world."

Spain and then Germany actually offer international investors the best returns on hedged loans, with 2.88% and 2.68% annual returns respectively.

The increased cost of hedging in the US is related to higher short-term interest rates.

 

Rising Deficits

The rising cost of funding comes at a bad time for the U.S. which is spending more than it is earning in revenues and importing more than it is exporting. The difference has to be paid for somehow - enter foreign lender.

The U.S. current account deficit is actually getting smaller, which is positive, it narrowed to 2.0% of GDP in Q2 from 2.4% in Q1.

The budget deficit, however, is getting worse according to recent data which showed it was set to climb to a 6-year high of -$779bn in 2018 - well above the -$666bn for 2017.

The U.S. administrations recent tax reforms have widened the budget deficit and although they have probably stimulated growth too, increased tax revenues are not keeping pace with spending.

In reality, total revenue growth in the US has been a dismal 0.4% in FY 2018, despite GDP rising 5.0%. The main reason for the lack of revenue growth is the massive 31% drop in corporate tax revenues, due to the generous tax cuts given to companies.

Revenue from increased trade tariffs failed to make up the shortfall left by tax cuts and although they rose 20%, only contributed a paltry 1.2% to total taxes.

One, especially concerning statistic given the high costs of hedging Dollar exposure, is that repayments of existing debt are expected to contribute the fastest rising costs for the US Treasury, rising by an estimated 24% for the year.

If the US government has to raise interest rates higher to attract foreign lenders the cost of servicing its debt will increase even higher and could strangle growth. The government would have to respond by drastically cutting spending or raising taxes or both and this would weaken the economy, and pressure the Dollar lower.

The U.S. budget deficit is set to widen to over $1 trillion in 2019 as spending continues to rise faster than tax receipts, according to a report by Wells Fargo.

"We also feel that medium-to-longer run risks for the USD are tilted bearishly due to rising U.S. deficits," says Shaun Osborne, chief FX strategist for Scotiabank in a recent report on the matter.

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