In the last week of January - just as the S&P was set to hit all time highs ahead of its sharp, 10% correction as vol finally woke up - we were discussing the looming monthly pension fund rebalancing sale of stock as a risk factor to equities. While there is more to it, the reason for this boiled down to the following: as a result of pension fund mandates and quotas, due to the persistent outperformance of stocks over bonds, in recent months pension funds had been forced to repeatedly reduce their equity exposure - or alternatively increase their allocation to bonds - at month end to maintain their stock/bond exposure limits. In other words, as long as stocks were on a tear, pension funds would be natural buffers to this meltup, periodically selling stocks while buying Treasurys.
This was ironic because just 3 weeks later, everything has changed, and after last week's dramatic stock market correction, suddenly the pension mandate has flipped, with the relative performance between stocks and bonds now meaning that pension funds have shifted from buyers to sellers of bonds.
Commenting on this regime shift over the weekend, Deutsche Bank's credit strategist called it an "enormous problem" for the following reason:
"the strong equity outperformance relative to fixed income had created a very large need for pension investors to harvest equity gains and redeploy those gains into fixed income or other asset classes to avoid repeating the mistakes of the Internet Bubble, when those same investors were slow to cut equity exposure and as a result were left with a generational problem when the bubble burst and funding levels fell precipitously. This was an enormous “problem”.
Until just over a week ago, equities were outperforming fixed income by nearly 8%, and we estimated that in order to maintain static portfolio weights defined benefit pension investors would need to sell nearly $100 billion of equity holdings, and re-allocate those holdings into fixed income. From a risk perspective, the total DV01 was over $130 million.
All of changed after the sharp decline in equities last week, when - according to Deutsche Bank - "this seemingly enormous source of demand for debt is substantially gone." Worse, per the bank's calculiations, what until two weeks ago was an implicit $100 billion bid for the fixed-income duration from pension investors had now become a re-balancing “offer”.
That is, equities outperformed fixed income to the downside, and – as of Thursday’s close - to maintain static weights, pension investors would likely have needed to sell between $10-15 billion of fixed income to buy equities, rather than vice versa.
As DB's rates strategist put it, "This was the world turned upside down."
Which of course is a problem, because the main reason stocks started selling off on February 2 is due to the hourly wage inflation "scare" (which we claim were far weaker and were fundamentally misunderstood by all), which sent real rates (and to a lesser extent breakevens) surging, amid worries about the ballooning US deficit, coupled with a Fed balance sheet that is now contracting and soaking up market liquidity. All of which combined, resulted in a sharp Treasury selloff. In fact, as we have demonstrated time and again, on every occasion when the 10Y US Treasury yield rose above 2.85%, the bid below stocks would mysteriously disappear, leading to a sharp downward swoon, which in turn would push yields lower, then rinse, and repeat.
And now it's worse, because if Deutsche is correct, "going forward the implication remains that pension demand [for fixed income] should be substantially more muted than even a week or two ago."
Translated: one more marginal buyer for the 10Y has stepped to the side, if only for the time being, which is a negative catalyst not only for rates, obviously, but also for risk assets, which continue to be driven by the total return correlation, forcing further risk parity and vol-targeting unwinds after the worst week since Lehman.
But wait, there's more.
As Deutsche Bank continues, should the ratio of equity/bond performance remain at Friday's level, "this leaves us wondering which investors are left to buy the long end." Here's why:
If the equity volatility continues, variable rate annuity issuers are likely to need to receive longer maturity fixed rates to hedge the rho exposure of the guarantee structures in recent VA issuance. Howver, if equities stabilize we would expect this demand to be short lived. Yen-based life insurers would have demand, but only when bond yields exceed the sum of hedge costs (1y hedge costs 2.55%) and JGB yields (80 bp). Pensions could have some residual demand to the extent that regulatory tightening drives some de-risking on the margin. Bond yields and USDJPY remain at levels consistent with historical triggers of purchases without currency hedges. However, the largest sources of structural demand in the long end appear to be largely on the side lines, absent an additional sell-off of roughly 25 bp at the long end.
So pensions - as a buyer of duration -are gone for now. What options does that leave? Well, as DB's Stuart Sparks writes, "the key question is how will the Fed view this market volatility." In other words, with US deficits set to soar, will the Fed reverse its tightening bias and resume monetizing the US deficit as it did for the duration of QE1 through QE3?
The question is indeed key, because as we discussed yesterday, according to Bank of America's Critical Stress Signal, we just crossed the level which on 5 out of 5 occasions since 2013 Central Banks have stepped in to ease market stress.
Well, based on recent central banker quotes (more on this shortly) there is no rush by policymakers to bailout markets. In fact, quite the opposite. Deutsche Bank's credit strategists agree. In fact, according to DB stocks would need to drop an addition 17% for financial conditions to reach a level desired by the Fed. To wit:
Our colleagues in economics argue that an additional 16-17% decline in equities would be required to reduce the prescribed level of an FCI-augmented policy rule by 25 bp. Note that we recently raised our expected end-2019 “terminal” short rate by 30 bp, from 2.45% to 2.75%, and raised our yield forecasts consistent with that Fed “baseline”, with our year end 10y Treasury forecast rising from 2.95% to 3.25%. While the tightening of financial conditions last week was acute, it must become chronic to materially change the Fed’s intentions. If anything, we think that more fragile risk assets will force the Fed to remain gradualist. This implies that if the terminal policy rate has risen consistent with our estimates, the Fed will have to add hikes sequentially in 2019 and potentially even into subsequent years. The risk then is that the Fed might fall modestly behind the curve temporarily. Note that when this means that “r” will be rising more slowly than “r*”, which is also a prescription for a steeper curve.
So - according to Germany's biggest bank - don't expect central banks stepping in to prop up the market until the correction is a full-blown bear market, and pensions are turning from bond buyers to sellers.
And so with rates set to surge, one wonders if all those algos who bought stocks on Friday afternoon just because i) Gartman again predicted a "full-fledged bear market is upon us" and ii) JPM again predicted that risk parities would not sell any more (something it incorrectly predicted also two weeks prior) will feel especially stupid come Monday morning.