Thank Record Stock Prices for a Flattening U.S. Yield Curve

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  • Pensions, other investors seen rebalancing ahead of year-end
  • Demand for the highest-duration Treasuries rises with equities
Wood, Rajappa on the Flattening Yield Curve

Bond strategists have a new favorite culprit for the relentless flattening of the U.S. yield curve: the stock market.

The gap between short- and long-dated Treasury yields fell to a fresh 10-year low this week, extending the trend that has dominated the world’s largest bond market for weeks. One reason the flattening dynamic has room to run is a shift in asset allocation among money managers in favor of long-dated Treasuries, according to a growing chorus of strategists. 

With the S&P 500 Index hitting another record, and year-end only weeks away, pension funds and investors committed to a balanced portfolio may want to lock in equity gains and add fixed-income, according to Deutsche Bank. Of course, it’s not exactly an ideal time to be purchasing 30-year Treasuries either -- they yield 2.75 percent, down from as high as 3.21 percent in March. But the duration at least serves as a hedge if the stock-market rally comes to an end.

“A substantial amount of flattening -- at least on the back end -- is the result of rising value at risk from equities,” said Thomas Tzitzouris, fixed-income research chief at Strategas Research Partners. “When equities drift higher to new highs, and volatility stays low in the yield space, buying bonds seems to follow.”

For more on the flattening yield curve, click here

The demand for duration lately has moved practically in lockstep with stock-market rallies, according to research from Ian Pollick, global head of rates strategy at Canadian Imperial Bank of Commerce. 

The correlation is close to 1 between changes in major equity market indexes and the amount of zero-coupon Treasury securities (known as strips) held by investors, he wrote Wednesday in a note. Pensions and other asset-liability managers are among the biggest buyers of those instruments.

“Monetizing equity market gains and moving into fixed income is part of the pension recipe -- especially considering U.S.-based pension funds face larger costs for holding unfunded obligations,” Pollick wrote. 

The largest U.S. pension fund is just one example of the de-risking trend. The California Public Employees’ Retirement System is mulling a reduction in its stock allocation to as little as 34 percent from 50 percent in favor of bonds.

"The outperformance by equities this year versus the bond market is an incentive to rebalance into the end of the year," David Ader, chief strategist at Informa Globalmarkets Inc., wrote in a recent note.

To be sure, strategists for months have been citing the allocation shift among real-money funds. That means it may only be one of many reasons for the accelerated flattening of the yield curve recently.

And for all the hand-wringing about equity valuations, U.S. stocks are in the throes of a spirited bull run, propped up by strong earnings and abundant inflows -- a buffer for the stock market if portfolio rebalancing gathers steam.

To Steve Feiss at broker-dealer Government Perspectives LLC, the shift may pick up heading into the final weeks of 2017, with the total return on the S&P 500 at 18 percent, versus 6.4 percent for the Bloomberg Barclays Global Aggregate Index.

“I firmly believe that stocks up so much year to date will be a source of some fixed-income flows as profits continue to be harvested,” said Feiss, an interest-rate strategist in Marlboro, New Jersey. “Eventually stock jockeys too have to realize this.”

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