BACK in the days of the gold standard, central bankers were very concerned about the views of international investors. They believed that maintaining the value of their currencies would reassure creditors. That is why they were so resistant to the idea of floating currencies. Georges Bonnet, a French finance minister, put it best

Who would be prepared to lend with the fear of being paid in depreciated currencies always before his eyes?

This fear still shows up from time to time. Under the old exchange rate mechanism, countries like Italy would undergo periodic devaluations to restore their competitiveness*. As a result, investors would demand a higher bond yield to compensate for this risk. When the single currency was planned, bond yields slowly converged on the German level as the risk of devaluation disappeared. It popped up again in 2011 and 2012 as investors feared some countries might drop out of the euro and reintroduce domestic currencies; that would have required a partial default. (Of course, Greece stayed in the euro but had its debts rescheduled.)

By and large, however, in the developed markets, foreign investors seem to accept remarkably low yields, despite the risks of currency loss. In the run-up to the Brexit referendum, gilt investors were getting a yield of a little over 1%. When the Leave side won, the pound immediately fell around 10% against the dollar, wiping out many years of bond income. At the moment it is not entirely clear whether the administration of President Donald Trump wants a weak dollar, but if its priority is to eliminate the trade deficit, a declining greenback looks essential. But at 2.7% the yield on the ten-year Treasury offers precious little compensation for currency risk.

The “clever” answer to this conundrum is that modern investors are more sophisticated and separate the investment and currency decisions; they simply hedge against a dollar decline. But it is not a very satisfactory answer. Someone has to take the other side of the hedge. In the short term, that might be an investment bank. But banks won't want to be overexposed to a dollar decline. They will seek to offload the risk. In aggregate, the market cannot hedge itself; someone else has to take the trade and what is in it for them?

A better argument might be that investors simply cannot know which way a currency will move. In the old days of fixed exchange rates, they had a one-way bet; troubled countries were very unlikely to revalue their currencies but they might devalue. Often, domestic investors were the ones to take fright, moving their money out of the country to avoid devaluation; bond yields had to rise to fill the hole they left. Nowadays, it is very difficult to predict currency movements on the back of fundamentals. Many people thought the dollar would decline once the Fed started to use quantitative easing (QE) but the other big central banks resorted to QE as well. The dollar may have declined in the last year but maybe the market trend will change again. As a result of this uncertainty, international investors will opt for a portfolio of government bonds from different countries, expecting that what they lose on the currency swings they will gain on the roundabouts.

The most convincing argument, in my view, is that many bond investors are not profit-maximisers; they own their bonds for different reasons. Central banks may own Treasury bonds as a way of managing their currency reserves, for example; pension funds and insurance companies may own them to match liabilities or for regulatory reasons. They are thus pretty indifferent to currency or indeed yield risk. The kind of investors who frightened central banks and governments in the past—the bond market vigilantes of the 1980s and 1990s—are only a small subset of the total. 

* The loss of competitiveness was usually down to higher inflation, so high-inflation countries were expected to see their currencies decline. This also led them to have higher short-term interest rates. An old law in finance was "covered interest parity". If country A has 12-month rates of 10% and country B has rates of 5%, then the former's currency will trade at a 5% discount in the forward market. Otherwise, there would be free money available for those investing in country A and hedging their currency exposure.