Bank of America Merrill Lynch is predicting an equity-rate convergence trade because of what it calls a trifecta of increasing U.S. treasury supply, declining demand and the need for pension and mutual funds to step up.
At the heart of the bank’s call is increased Treasury supply over the next five years – anywhere between $3 trillion and $4.5 trillion. “There are few things more certain right now than increased Treasury supply,” it asserted in its U.S. Rates Viewpoint newsletter.
But unlike prior cycles, traditional and price insensitive sources of demand – reserves, domestic banks and Federal Reserve – cannot absorb the substantial increase in supply of UST. This means the duty of absorbing the increased supply will rest on value buyers such as foreign private investors, domestic pensions and fixed income mutual funds. In this equation, the foreign private community has faded on account of the end of quantitative easing by the European Central Bank and Bank of Japan, leaving an estimated $1trillion shortfall to be met by domestic pensions and mutual funds.
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This trillion dollar mismatch in Treasury supply/demand dynamics over the next five years will likely trigger an equity-rate disconnect correction, Shyam S. Rajan, the bank’s rates strategist, asserted.
BAML factored baseline deficit projections, maturing debt, Fed run-offs, projected tax cuts and a likely recession to quantify the projected increase in Treasury supply. While current coupon auction sizes are just enough to cover baseline maturing debt and deficit projections for 2018, they begin to steeply fall starting 2019. Potential Fed portfolio run-offs and tax reform package in Congress could raise the shortfall to $800billion-$1 trillion a year starting as early as next year. Consequently, the U.S. Treasury will be underfinanced by a cumulative $3 trillion-$4.5 trillion over the next five years.
To fully fill this gap, the clearing level for rates would need to be nearly 120bp higher; and for mutual funds to have enough inflows to justify this demand, equities would have to be nearly 30% lower, the bank estimated.
“This is clearly a simplistic framework given its assumptions around linearity. For example, pensions could use nonlinear glide paths – adopting a very risky strategy if underfunded and substantially lower risk allocations as funded ratios move past 90%. Similarly, investor outflows from mutual funds during risk-off shocks of 10% will likely more than simply double a 5% correction episode. Nevertheless, this provides a first order framework to evaluate what ‘price sensitivity these particular investor bases would require to account for a trillion dollars of additional bond demand.”
BAML’s math for pension funds is as follows:
Currently, the projected pension obligations of the top 100 corporate defined benefit plans stand at $1.71 trillion with a funded ratio close to 85% (~$250bn deficit). More importantly, the rate sensitivity of pension liabilities more than dwarfs the equity sensitivity of pension assets. The empirical sensitivity of the combined funded ratio to rates stands at roughly at $2.1bn improvement for every 1bp increase in 30y rates.
The bank further states:
Currently, asset allocations for these pensions stand at ~ 35% equities, 45% fixed income (with 20% in other assets). Ignoring costs and funded status volatility considerations, it is reasonable to assume that as pensions reach a 100% funded ratio, they will likely move out of equities to a fully fixed income portfolio (as companies don’t benefit from overfunding). So in the most simplistic case, a 120bp increase in rates, will lead to a $600bn outflow from equities into bonds (35% of $1.7 trillion) from the top 100 plans. Scaling this up to the entire universe of DB plans ($2.9 trillion) would suggest that a 120bp increase in rates, will lead to a total of ~$1 trillion in demand from this community for fixed income assets.
In the emerging scenario, BAML recommends two ways for investors to go beyond the “plain vanilla convergence trade” between equities and rates.
we would fade the richening of receiver skew in the belly of the rates curve (1y5y 25bp out payers are at the same level as 25bp OTM receivers).
Secondly, from a cross-asset perspective, the bank said equity and credit puts offer better hedges than rates receivers. “This would skew us to hedging risk-off through other asset classes and higher growth/inflation through higher rate hedges,” the bank said.