Higher US interest rates could well tempt investors into believe investing in US bonds is the better choice right now, but there are arguments for and against this approach.
Economic theory would have us believe one country has higher interest rates than another because of differences in inflation rates and economic stability.
If one country has higher inflation than another (for example, inflation in Zimbabwe is almost 50% year-on-year), it must pay higher interest rates (150% in Zimbabwe) to attract investors, cool off the real economy, and compensate for the risk of lending money to it.
Nevertheless, if we compare the US with Europe, where both have relatively similar inflation data, you could be forgiven for wondering why Federal Reserve rates are now at 5.25%, while the European Central Bank has rates at 4.5%. See the chart below.
True, US inflation is usually higher than in the eurozone (the latest February CPI data for the US put year-on-year inflation at 3.2%. In the eurozone it's 2.6%), but the chart below shows how inflation in the eurozone reached 10.6% in October, compared to a peak of 9.1% in June. The Fed's rates, meanwhile, were always higher than the ECB's. It's therefore difficult to explain the difference in central bank rates simply by using inflation as the only comparator.
The answer lies in the difference in economic strength displayed by the two economies. The graph below shows GDP growth rates in the US and Europe over the four quarters of 2023. Clearly, the European economy was much weaker than the US economy. Moreover, US growth has been increasing, while eurozone growth has been going in the opposite direction.
Insofar as the US economy can afford higher rates than the eurozone, this has an important consequence for central banks – hence the difference in interest rates.
US or European Bonds: Which Should I Choose?
The big question for investors is whether there is a way to benefit from higher interest rates in the US. That applies to any part of the interest rate curve (the interest rate curve is the graphical representation of the relationship between the yield or interest rate of a country's sovereign bonds and their maturity). Logically, it is better to invest in a bond yielding 4.5% than in a bond yielding 3%. See below.
It would then be more interesting to invest in US bonds than in Eurozone bonds as they offer higher yields. But there are two further considerations to account for.
How Does Currency Risk Affect my Bonds?
Yes, US bonds pay more interest than European bonds, but the European investor has to take a dollar risk, which can be beneficial or detrimental.
For example, if we compare two exchange-traded funds – such as the iShares € Govt Bond 1-3yr ETF EUR and the iShares $ Treasury Bd 1-3y ETF USD – which invest in the same tranches of the interest rate curves, one in the Eurozone and the other in the US. If we compare their performance in euros over the last 12 months, there is a significant difference, as can be seen in the chart below.
How Can I Hedge Dollar Risk in Bond Investing?
One option is to hedge the dollar risk, where possible. Many dollar bond funds tend to have a euro hedged class, which means they do not assume they immune from currency fluctuations.
However, hedging dollar risk costs money, and the cost is the interest rate differential between the dollar and the euro, eliminating, at least in part, the supposed advantage of investing in the US because of its higher interest rates.
In fact, if we compare the performance of an ETF such as the iShares Euro Government Bond 1-3 Year (a European government bond ETF with maturity between 1 and 3 years) and the iShares USD Treasury 1-3 Year EURH (a US government bond ETF with maturity between 1 and 3 years and with the currency hedged) over the last 12 months, it is the European government bond ETF that achieves the best return.
Why is the European debt ETF more profitable than the Euro hedged US debt ETF that invests in the same part of the curve? There may be small differences in the duration of the portfolios of these two ETFs, but they are minimal.
What there are, however, are differences in the evolution of rates in the US and in Europe within the same part of the curve. For example, the attached chart illustrates how 2-year bond rates on both sides of the Atlantic have varied over the past 12 months. They are not identical movements and this leads to different yields.
