Thursday, July 5, 2018

US Corporations Behind Rally in Treasurys?

Ben Eisen and Daniel Kruger of the Wall Street Journal report, Tax Wrinkle Spurs Pension Funds to Buy More Treasurys:
U.S. companies are funneling extra money into their pension funds to take advantage of temporary tax savings, moves that are helping suppress yields on long-term Treasurys.

S&P 500 companies are contributing to pension plans this year at a pace expected to nearly match 2017’s level, which at $63 billion was the most since 2003, according to Goldman Sachs Asset Management. Last year’s contributions were spurred in part by companies anticipating changes in the U.S. tax-code overhaul.

That and continued contributions this year have been a boon for the Treasury market because pension funds tend to invest in long-dated bonds to match their long-term liabilities. The yield on the 30-year bond has been falling recently, closing at 2.953%% on Thursday, down from a recent peak of 3.245% in mid-May.

Analysts are pinning the drop in yields—which happens as prices rise—partly on demand from pension funds. Long-term rates have remained low and U.S. inflation has picked up this year. Inflation poses a risk to bonds, and especially longer-dated ones, because it erodes the purchasing power of fixed-interest and principal payments.


Long-term yields are “very low because people are still putting money into Treasurys,” said Torsten Slok, an economist at Deutsche Bank . The difference between yields on 30- and 10-year Treasury debt has shrunk to about 0.13 percentage point this week from about 0.33 percentage point at the start of this year.

Voluntary contributions to pension funds, which already were brisk last year, have taken off recently thanks to the passage of the tax overhaul. This introduced a window for companies with underfunded plans to make additional contributions and garner a tax benefit, analysts say.

Firms that contribute through mid-September of this year can receive deductions based on the old 35% corporate tax rate, rather than the new 21% rate. A company that contributes $1 million to an underfunded pension plan could have $350,000 in tax savings before the deadline, but would have savings of just $210,000 after September.

Those making discretionary pension contributions include Verizon Communications Inc., which added $1 billion to its pension plan in the first three months of the year, a large enough sum that the telecom giant won’t have to make mandatory contributions for eight years, the company said in April. A Verizon spokesman said the tax benefit was a factor in the contribution.

PepsiCo Inc. said in April that it made a discretionary contribution of $1.4 billion. Deere & Co. and United Parcel Service Inc. both have cited the tax law as the reason for increasing their voluntary pension contributions.

“You will probably see more do it over the next few months,” said Michael Moran, a pension strategist for Goldman Sachs Asset Management.

One sign that pensions have a lot of fresh money to pour into U.S. government debt is strong demand for what are called stripped long-term Treasurys. These securities are created when bond dealers cleave a bond into separate interest-only and principal-only instruments.

Pension funds often purchase the principal-only instruments, which are akin to zero-coupon bonds. The funds purchase the debt at a deep discount, forgo regular interest payments and instead receive the debt’s full face value at maturity. This gives pension plans funds when a liability is coming due and provides them with more financial flexibility in the meantime.

The amount of stripped long-term Treasury bonds rose 9.4% in the first five months of 2018, putting them on track to grow at more than twice the pace of the previous year, according to data from BMO Capital Markets. That would mark the fastest growth since 2010.


Pension-fund purchases of both principal-only stripped long-term Treasurys and Treasury debt have played a key role in keeping long-term yields low, analysts said. And pension funds’ debt appetite may grow in coming months as companies that have been waiting for higher rates make their move before the tax window closes, said Richard Sega, chief investment officer at Conning, who manages money for insurance companies and pension funds.

After that, though, pension funds could have a reduced appetite for longer-dated Treasurys. Combined with a quicker pace of government-debt issuance due to growing deficits, this could help to push yields higher, said Deutsche Bank’s Mr. Slok.

Demographic shifts toward an older workforce, though, could lead companies to continue increasing pension-fund contributions. Meanwhile, companies and governments in developed economies outside the U.S. will face similar demographic challenges, which also would lead to more Treasury buying, Mr. Sega said. “This is a long-term global trend,” he said.
This is an interesting article that caught my attention for a few reasons. First, companies may be increasing contributions to their pensions to take advantage of tax cuts and this could be a factor driving the rally in US 30-year bonds.

However, I caution you there is something much bigger at play here than corporate pensions buying long-dated bonds to take advantage of the tax overhaul.

Importantly, with the US yield curve at an 11-year low, investors are bracing for a slowdown. The question is will it be a soft or rough patch ahead.

Slower growth ahead means inflation pressures will peak this summer and that is very bullish for US Treasurys.

In fact, have a look at the one-year daily and five-year weekly charts of US long bond prices (TLT) below and you'll see there is a mini-rally going on in US long bonds recently and this despite stubbornly high oil prices (click on images):



What's going on? Well, I've told you, the global economy is slowing and that's the number one factor driving US long bond yields lower (prices higher) and it's no surprise that the recent rally in US Treasurys coincides with the selloff in emerging market stocks (EEM):


How low can emerging market shares go? They can go much lower, especially if a full-blown trade war breaks out and the US dollar (UUP) keeps soaring:



Will we get a crisis this summer or this fall? Maybe or maybe not, it's too early to tell.

This comment was to warn investors to ignore a lot of nonsense in the media about corporations driving Treasury yields lower and once the tax advantage evaporates, yields are headed higher. At the margin, their contributions help, but there is something else going on here, something much bigger and potentially more sinister.

Below, Brett Gillespie, head of global macro at Ellerston Capital, discusses global markets. I definitely don't agree with his wage inflation views as evidenced by a tweet Neel Kashkari put out yesterday stating "Historic worker shortage":



But it's worth listening to his views on emerging markets and the dollar.

Emerging market equity flow has been unwinding, strategist says from CNBC.

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