Europe's Foreign Debt Binge Could Push U.S Rates Lower

European investors are buying more foreign bonds than ever before, another sign that many fund managers aren't expecting tapering from the European Central Bank to boost local yields anytime soon.

The trend has global implications. Heavy demand from the eurozone puts pressure on yields elsewhere in the world, including the U.S., and lowers borrowing costs there. The eurozone's investors are big spenders: In 2016, local investors bought around $500 billion in foreign, mainly government, bonds, almost enough to cover the entire $584.7 billion U.S. budget deficit.

The most recent numbers, between May and July, show that the eurozone's investors bought EUR160.8 billion ($191.7 billion) in international bonds, the largest sum in any three-month period on record, according to data from the ECB.

ECB stimulus, including negative interest rates and a massive bond-buying program, have pushed down the yields on local government debt to record lows. That has made investors look elsewhere for returns.

Now, robust growth in the eurozone is raising expectations that the ECB will roll back its monetary policy, easing more quickly than once expected. As ECB buying subsides, that should push yields higher.

But eurozone investors don't appear to be buying into the idea that local yields are about to get more attractive.

In June, ECB President Mario Draghi said that "all the signs now point to a strengthening and broadening recovery in the euro area," in a statement that investors interpreted as being the central bank laying the ground for tapering. But that didn't stop eurozone investors from snapping up EUR40.9 billion in foreign bonds in the following month alone.

"The rhetoric is about higher rates and tapering...but the reality is that government bond yields and interest rates in Europe are extremely low and even negative in some places," said Mouhammed Choukeir, chief investment officer at Kleinwort Hambros.

"So you're going to see that continued search for yield overseas."

European government bond yields haven't shifted significantly against their global peers since the ECB began changing its tone on tapering.

That is particularly so in the short-dated government bond market.

German two-year bund yields are now 2.1 percentage points below U.S. two-year Treasury yields, a gap that has widened from 2 percentage points six months ago.

That is partly because the Federal Reserve has already moved on tightening its own monetary policy. On Wednesday, Fed officials kept the door open for a December interest-rate rise at the conclusion of their September meeting. Officials also said that they would begin shrinking the Fed's portfolio of bonds in October.

"There is a good chance the ECB hasn't done any hikes by the end of 2018," said Mike Bell global market strategist at J.P. Morgan Asset Management. "Whilst that gap between very low bond yields in the eurozone and somewhat higher global yields persists, you could well see continued large foreign bond purchases," he added.

All that could mean lower borrowing costs for Americans.

In 2012, the Fed published a research paper estimating that a $100 billion increase in foreign official demand -- from institutions like central banks and sovereign-wealth funds -- reduces the five-year Treasury yield by 0.4 to 0.6 percentage point in the short-run.

Adding to the attraction of investing abroad for European investors: The cost of hedging their exposure to movements in foreign currencies has fallen this year.

A five-year cross-currency basis swap currently costs a European investor around 0.35 percentage point above interest rates -- allowing them to borrow in dollars and hedge their risk -- down from a peak of 0.56 percentage point last year.

Still, despite European investors buying their bonds abroad, the eurozone is now registering inflows in the equity market, a trend that some analysts don't see reversing soon. Earnings have picked up in Europe, and compared with U.S. stocks, equities in the region are relatively cheap

"Looking at the growth momentum and the economic reform story, we expect that to continue," said Jordan Rochester, strategist at Nomura.

Write to Mike Bird at Mike.Bird@wsj.com

(END) Dow Jones Newswires

September 22, 2017 05:44 ET (09:44 GMT)