Thank record-high stock prices for flat U.S. bond yield curve

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

The gap between shortand 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 favour 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 per cent, down from as high as 3.21 per cent 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 on the back end — is the result of rising value at risk from equities,” says 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.”

The demand for duration lately has moved practically in lockstep with stockmarket 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 per cent from 50 per cent in favour of bonds.

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

And for all the handwringing 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 brokerdealer 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 per cent, versus 6.4 per cent 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, N.J.

“Eventually stock jockeys too have to realize this.”