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With the Bearish Bets on the Euro Climbing but EuroZone Exports Increasing, I'm Adding a Hedged ETF Focused on Germany
03/12/2015 7:08 pm EST
Given that many big money managers are now talking about this decline in the euro going on into 2017, MoneyShow's Jim Jubak is adding a hedged ETF with a focus on Germany to his portfolio as of Friday, March 13.
Hedged or unhedged?
I’ve spent the last week thinking about whether it was better to use a hedged or unhedged ETF to invest in a European export-oriented economy such as Germany or Poland to play the asset purchase program that the European Central Bank announced in detail on Monday, March 9.
I had been inclined to say, unhedged. I can easily remember when everyone thought the drop in the euro would end at $1.25 or $1.20, or most recently at $1.10, or at parity with the dollar ($1.00).
The euro closed at $1.0551 yesterday, March 11. If the bottom was $1.00 that was only a further 5.2% drop from here—not a terrible risk—and if the euro were about to rally, then I’d sure like to participate in the bounce. Hedging my euro risk would just make sure I didn’t get any benefit from that bounce.
Now, however, big money managers are talking about this decline in the euro going on into 2017. For example, Deutsche Bank, which was bearish at the euro at the beginning of the year, has gotten even more bearish. The bank is now talking about parity for the euro to the dollar by the end of 2015 and then a continued decline to 85 cents to the euro by 2017. (That would take the currency back to near its all time low against the dollar.)
Yipes. That’s a 19% drop in the euro. Enough of a potential currency loss to wipe out much of any potential gain in share prices.
As of tomorrow, March 13, I’m adding iShares Currency Hedged MSCI Germany ETF (HEWG) to my Jubak’s Picks portfolio. (I’m picking this ETF above competitors Wisdom Tree Germany Hedged Equity ETF (DXGE) or Deutsche X-trackers MSCI Germany Hedge Equity ETF (DBGR) because it is about ten times larger, and in this market, I’m more comfortable with more liquidity rather than less.) The iShares Hedged Currency MSCI Germany ETF closed at $28.34 on March 12. The expense ratio (with fee waiver) is 0.53% and the ETF yields 1.76%. I calculate a target price of $34 a share by the end of 2015.
So, why have some big investment houses become so much more negative on the euro lately…and why do I believe them?
It’s a reflection of a deeper study of how the European Central Bank’s program of asset purchases is likely to affect interest rates in the EuroZone. The conclusion is that the plan will send already low rates even lower.
I know that sounds impossible. After all, the 2-year German note already yields a negative 0.25% and the 5-year note yields a negative 0.13%.
But it’s not impossible that yields will go lower. It’s actually probable, given the structure of the bond market in the EuroZone.
Here’s the problem: Thanks to the EuroZone’s focus on austerity, member countries haven’t been issuing much new debt. And they don’t have plans to issue much new debt.
Net issuance of new debt in the EuroZone between now and September 2016—the projected life span of the European Central Bank’s asset purchase program—is projected at just 413 billion euros, according to JPMorgan Chase. I say just because the European Central Bank wants to buy 850 billion euros of debt securities. That leaves new supply short of central bank demand by a huge 437 billion euros.
That’s how much the central bank will need to buy in already issued bonds from current owners. To pry them out of the hands of current owners, the European Central Bank will have to offer to pay higher prices and higher prices translate into lower yields. (Especially since many banks hold these kinds of assets as core parts of a capital base required by regulators.)
The problem will be most acute in the market for German bonds, where the bank will be looking to buy 200 billion euros of German government debt and the supply of newly issued debt will be just 6 billion euros during this period.
Getting current bondholders to sell isn’t going to be easy in the case of large institutional holders such as insurance companies and pension funds. These institutions own these bonds because they match projected liabilities in both payout and maturity. Exactly what are these companies supposed to buy to achieve those goals if they do sell their current holdings?
Part of the more negative assessment of the effect of this program of asset purchases on yields and the euro reflects calculations of how quickly asset purchases will reduce the supply of bonds suitable for purchase. The European Central Bank’s plan says that it won’t buy any bond with a negative yield of more than 0.2%. That’s the price that the central bank now charges individual banks to keep deposits in central bank vaults. The negative 0.2% figure is an effort to limit the losses the central bank would take if it buys a bond with a negative yield and yields then wind up climbing. (As they would at some point if this program of asset purchases does indeed increase growth and inflation rates.)
But look how that limit works to reduce supply. Once upon a time—like Tuesday, March 10—the central bank could buy German notes maturing in April 2018, a little more than three years from now. But yields on those notes fell as the price of those notes climbed, so that on Tuesday, yields fell to a negative 0.23% and these notes were no longer allowable purchases by the central bank.
In effect, purchases—or anticipated purchases—by the European Central Bank acted to reduce the supply of bonds available for purchase and to increase the upward pressure on the prices of remaining bonds in the market…with the result that yields on those bonds fell too.
Much of the early worry about this process has focused on the question of whether or not the supply of bonds available for purchase would be exhausted before the program of asset purchases reached an end.
The more recent focus, however, has been on the effect of the asset purchase program on yields now. And the result of this analysis has been to suggest that European bond yields will be in the midst of an even deeper drop just as the US Federal Reserve begins to raise interest rates in June or September.
And that will mean, this analysis says, an even weaker euro than projected earlier.
Of course, there is always the additional possibility that the European Central Bank’s plan won’t work—in which case—the central bank will arrive in September 2016 having spent 1 trillion euros on asset purchases with nothing to show for it except deeper negative interest rates on a larger portion of the existing European bond supply.
You can bet the euro would love that.
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