International diversification for bond allocations is, in theory, an attractive concept, but in practice it’s not working out so great in 2021 for US investors, based on a set of ETFs.
Five of eight funds selected to represent this slice of offshore fixed-income markets are posting substantially deeper losses than the US benchmark via Vanguard Total US Bond Market (BND), which is down 1.8% so far in 2021.
That’s a mild loss relative to several foreign bond ETFs. The deepest cut in this corner: foreign government bonds in developed markets via SPDR Bloomberg Barclays International Treasury Bond (BWX), which is off 7.9%.
By contrast, two foreign bond funds are posting gains year to date: investment-grade (EMCB) and high-yield (HYEM) corporates in emerging markets.
A key headwind for foreign bonds is the rebound in the US dollar. (Unhedged foreign assets are priced down after translating from foreign currencies to dollars.) After a rally that reversed in the first half of this year, the US Dollar Index has been trending higher again since June and is now up 5.0% year to date. One catalyst that probably supporting the greenback is higher interest rates in the US vs. elsewhere among the major economies.
“As the U.S. escapes the interest rate zero-bound, leaving the Eurozone and Japan behind, the global savings glut is set to be drawn towards the dollar, which can outperform the majority of other currencies in the coming year, and may start its move earlier than we expected,” advises Kit Juckes, macro strategist at Societe Generale in a research note.
The dollar’s strength is perplexing at a time when the US is working through several challenges, including the risk of a government shutdown and the possibility that that Congress won’t raise the debt ceiling next month, which would result in a default of US Treasuries. But investors appear to be looking through those threats and concluding that political brinkmanship will eventually give way to sensible fiscal decisions.
The dollar’s bullish tailwind could reverse in a heartbeat if gridlock strengthens in Washington. But for the moment, it appears that cooler heads are winning. For example, the Senate now looks poised to approve a deal to avert a government shutdown.
That leaves the debt ceiling as the main stumbling block for the near-term outlook. Treasury Secretary Janet Yellen told lawmakers this week that the federal government will probably run out of cash by October 18 unless the debt ceiling is raised by Congress. Using the Dollar Index as a guide suggests that the market is betting this will be resolved before that drop-dead date.
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