This article first appeared in Forum, The Edge Malaysia Weekly on February 27, 2023 - March 5, 2023

As the world sees an end to cheap funding courtesy of higher US Federal Reserve interest rates, structural shifts may be coming to global finance. Bloomberg reported last week that money has been pouring into European fixed income products following steps by the European Central Bank (ECB) to lift benchmark interest rates to 3% per annum. Inflows since the start of 2023 of around €30 billion (RM141 billion) have reversed a decade-long trend of outflows due to the ECB’s zero-to-negative rate stance since 2008. Are these market movements transient or are we witnessing a structural shift back to home bias?

Before globalisation, it was natural for home bias, meaning domestic investors’ preference to invest in domestic bonds and equities rather than diversify into foreign assets. The reasons for home bias were higher transaction costs in trading foreign assets; lack of familiarity with foreign risks; and insufficient access to trustworthy intermediaries. The globalisation of fund management has reduced transaction costs, while regulations forcing domestic pension and institutional managers to invest their money in domestic government securities and foreign equities have been removed in the name of opening up to global markets.

If you look at the European Union’s net investment position (net foreign claims less foreign liabilities), the EU shifted from a net liability position of US$2.9 trillion in March 2008 (at the outset of the global financial crisis) to a net surplus of US$469 billion by September 2022. In other words, Europe has become a major net investor in the rest of the world, especially in US dollar assets.

Part of this is due to the interest differential and the equity premium that investments in US bonds and equities had over European rates. Even though the Fed took the lead in tightening monetary policy to 4.75% per annum, up 450 basis points (bps) since the start of last year, the ECB is catching up. Market analysts think that the ECB might increase rates by another 125bps because of higher European inflation, compared with an anticipated increase of 75bps by the Fed. There is still a long-term yield gap of around 140bps between 10-year US Treasury bonds and the 10-year German bunds. In 2018, when the Fed led in rate hikes, the spread between these two key instruments widened to 250bps. Not surprisingly, the euro devalued significantly against the US dollar.

In 2022, the spike in energy prices from the Ukraine war caused a current account deficit for the EU region. This fed through to inflation which rose steadily to a peak of 10.6% last year. Mindful of the fiscal impact on member states due to higher interest rates, the ECB expanded bond buying measures to manage the interest rate differentials between EU states. This calming action has helped to keep the spread between Italian bonds and German bunds at around 190bps. Italy, the most indebted EU member with public debt at 150% of GDP, had its highest yield difference with German bunds of 500bps during the 2012 debt crisis. Italian long-term fund managers would have an incentive to keep buying Italian bonds to help the national fiscal situation. Home bias comes primarily from self-interest.

The ECB has to balance between two conflicting objectives of raising rates to control inflation and keeping bond prices attractive, so that it can gradually unwind its massive bonds portfolio worth about €5 trillion. To make up for the difference, investors that once fled these markets for fear of negative yields will need to be lured back. Fund managers are being attracted by the positive yield return. Some European bond funds had received 18 consecutive weeks of inflows as at last fortnight, as reported by data provider EPFR. Furthermore, in 2022 euro bond funds holders began to rotate their short duration investments into long duration ones, suggesting some degree of investor comfort that back-end yields have stabilised. If so, the EU region, the largest exporter of foreign funds in the last decade, may be keeping more funds at home or rather exporting less savings abroad.

This home bias factor will have opposing effects on other markets. EPFR noted that high yield and emerging markets bond funds had substantial withdrawals two weeks ago. This would put stress on many emerging market economies (EMEs) with chronic current account deficits and high external debt. Having relied on foreign funding to make up a financing gap, persistent outflows can end up exposing structural weaknesses. If EMEs do not want to raise interest rates for fear of slowing domestic growth, then their exchange rates will depreciate against the US dollar or euro.

So far, Japan has been reluctant to participate in rate hikes. The central bank has stubbornly defended the country’s near-zero yield curve despite continued outflows of funds. Like Europe, Japan was also affected by the rise in energy prices, with a larger trade deficit and weakening yen throughout 2022. Faced with mounting domestic inflation and a shrinking current account surplus, the Bank of Japan may well find itself pressured to raise interest rates. This poses fundamental questions over the country’s role as an exporter of capital. Japan’s net international investment position reached US$3.17 trillion in September 2022, down from US$3.32 trillion in the previous quarter.

In short, if both Europe and Japan as the surplus countries begin to focus on home bias, there will be implications on the largest debtor nation, the US. If home bias is a reflection of the deglobalisation of domestic savings, then structural changes are on the cards for major exchange rates.

As the saying goes: “Better the devil you know than the devil you don’t”. When faced with both positive and rising yields, while geopolitical risks rise, it is not surprising that investors may be willing to accept a slightly lower return on domestic assets rather than risk marginally higher yields in foreign assets.

In short, home bias may be returning in an era of higher global volatility. That in itself will change the structure of global markets.

Tan Sri Andrew Sheng writes on global issues that affect investors. Tan Yi Kai is a Malaysian multi-asset trader based in Hong Kong.  

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