Forced Selling from Risk Parity Funds Will Push Up U.S. Real Treasury Yields, Says BofA
Some $50 billion worth of bond sales from risk parity portfolios is just one of the reasons why Bank of America Merrill Lynch is flip-flopping on its favorite trade of 2016, now recommending that investors begin to short inflation-protected Treasury debt.
The ability of risk parity strategies — which typically rely on bonds moving in the opposite direction of stocks in order to appropriately diversify risk across the portfolio — to withstand the potential end of a multi-decade bull run in debt and simultaneous slump in equities has become a hot topic over the past year. The debate has been revived in recent months as analysts and investors fret over the ability of such systematic strategies to exacerbate swings in the market and worsen losses.
"Our equity analysts estimate that the recent moves — bond and equity sell-off — could trigger as much as $50-billion in bond selling from risk-parity type investors," writes Head of U.S. Rates Strategy Shyam Rajan in a note published on Thursday. "While data on holdings is minimal, the influence of risk parity deleveraging on real rates is clear."
A positive correlation between stocks and bonds during the 2016 rally contributed to the outperformance of risk parity portfolios, which at their basic level employ a long, levered position in bonds with a long position in stocks. But that also means this strategy has taken it on the chin as stocks and bonds sold off in unison on Friday, extending their declines, in aggregate, through the first three sessions of this week.
In a separate report, BofAML equity strategists said that the price action on Friday represented a shock "likely larger than Brexit for quant funds," and suggested massive systematic selling would ensue over the coming sessions.
Another of Rajan's colleagues, Head of Global Rates and Currencies Research David Woo, has been pounding on the table that the potential for fiscal stimulus following the U.S. election — particularly if Donald Trump is elected — poses a huge threat to risk parity portfolios.
"Risk parity underperformance has historically meant higher real rates and lower breakevens," writes Rajan. "To us, the focus on risk parity unwinds is here to stay even beyond the next couple of weeks."
In addition, the strategist says the prior rally for real rates was a magnet for assets, with funds that hold inflation-protected debt seeing their biggest inflows in six years — even though we're only about three-quarters of the way through 2016.
"Chasing real duration at close to record lows in real yields while the idea of both a slow Fed[eral Reserve] and low r* [the natural rate of interest] are already well digested by the market does not look appealing to us," he adds.
What's more, the strategist thinks that 'quantitative tightening' — or the sales of foreign, typically U.S. dollar denominated, holdings by central banks (notably China) in an attempt to support their domestic currencies, which were at the heart of the last shock to risk parity portfolios in the summer of 2015 — might be back.
"While the exact source of reserve sales is not clear, the [yuan's] cheapening post Brexit, its stickiness around the 6.70 level and the pickup in custody decline could be an indication Chinese sales of U.S. Treasuries have resumed," the strategist writes. "The continuing gradual unwind of reserve demand should be a headwind for real rates."