Nominal yields in different currencies often differ for the relatively uninteresting reason that inflation expectations are different (component #2). This makes it impossible to look at the nominal yield and discern anything about the credit spread (component #3). The fact that euro-denominated German debt is trading at yields below dollar-denominated US Treasury debt does not by itself indicate the US Treasury is a riskier credit than Germany. It could simply mean that inflation expectations for the euro are lower than for the dollar.
These inflation expectations are more than just abstract estimates. Since they are derived from active currency forward markets, they represent executable levels for a cross-currency investor. We can easily observe the market’s valuation of currency exchange by looking at currency forward contracts. For example, the current exchange rate is $1.38 dollars per euro, while a five year currency forward is trading at $1.46 per euro. That difference implies the market is pricing in about a 1% per year depreciation of the dollar vs. the euro, which is consistent with a 1% inflation differential. Only by calculating a US dollar
yield for the German bond’s euro cash flows – effectively factoring out the currency difference – can we determine if German bonds are truly trading at a spread to US Treasuries that might indicate higher default risk. In Exhibit I, we show the results of this calculation for a handful of major sovereign issuers in different currencies.2
For example, we see that the “headline” spread of Spain’s debt to US Treasury debt is 0.1%, which is consistent with the highest grade, AAA-rated US corporate bonds. However, the currency adjusted spread of 0.9% is many times greater and presents a more informed measure of the relative risk of Spanish debt, implying a two notch rating difference consistent with A-rated US corporate bonds. In Exhibit II (next page), we show the historical adjusted spread over recent years.