While mom and pop investors and BTFDers (if not so much hedge and mutual funds and other “smart money”) have been delighted by the latest V-shaped surge in stocks, it has come as we have repeatedly shown…
… at the expense of collapsing long-term yields as another central bank liquidity tsunami is priced in. In fact, early Friday both 10Y and 30Y US Treasury yields plunged to new all time lows, a signal which at any other time would suggest a deflationary tsunami is about to be unleashed, but in this case simply meant that another bout of central bank generosity was coming to prop up risky assets in the aftermath of Brexit.
The problem is that while stocks can – for now – ignore this historic divergence, which has pushed the S&P back to just shy of all time highs while bond yields are at all time lows, one major market participant can no longer pretend to not notice what is going on. We are talking about pension funds, who according to Bank of America are about to “throw in the towel” and capitulate on the de-risking of their portfolios, unleashing the next major buying spree on the long end, in the process likely pushing the 10Y to 1% or even much lower.
As BofA’s Shyam Rajan writes, bull flattening of yield curves is rarely good news to anyone – but defined benefit pension plans are most leveraged to this pain. According to the most recent Milliman estimate, the average funded ratio of the top 100 US corporate defined benefit pension plans already had dropped to 77% by end of April. Since then, 30y rates dropped another 50bp and corporate spreads have tightened. While the asset side has provided some relief given that equities are hanging on to the highs, we think it is safe to assume that funding ratios over the last month have now reached the lows seen in 2012 – a rather sobering thought given that the equity rally of 70% since then has meant nothing and has been subsumed by the rate decline. The dominant factor of pension funding gaps has been the move in rates, as Chart 2 makes clear.
According to BofA there are five reasons why capitulation is more likely now.
Talking about pension capitulation seems counterintuitive when funded ratios are at record lows on the heels of a significant decline in rates. After all, why would a pension manager hoping for mean reversion at the beginning of the year feel forced to throw in the towel at these levels? 10y rates have been here before, funding ratios have been this low before, and this is not the first time for a flight to quality out of Europe and Japan into the US. What makes this time different? We identify five reasons (three macro, two pension-specific) that make capitulation this time around much more likely:
Here are the reasons:
1. Longer term growth
The key difference from a few years ago is the formalization of the “new normal†in the markets. Global estimates of neutral real rates are much lower, the Fed’s estimate of the long-run rate has dropped nearly 100bp, and the yield curve in itself sends a bleak message (Chart 2). While in 2013, 10y rates reached similar levels and the market pushed out the Fed nearly three years, it remained optimistic for the long run. Terminal rates were priced to be north of 3.5%, with forward inflation expectations above the Fed’s target. Today, every intermediate forward beyond 3y1y is 50-200bp lower than the lowest point in 2013. There is greater understanding that the yield moves are not temporary but a glaring reflection of the new normal across the globe
