Pension funds are ramping up their purchases of Treasury zero coupon bonds, potentially undermining the yield curve’s ability to act as a recession indicator.
Investment banks will separate a bond’s interest and principal payments, the latter of which is mostly sold as zero coupon debt to pension funds who need assets that can match their long-term liabilities. Mostly from the long-end of the bond market, around $6 billion of Treasurys saw their principal and interest payments separated in May, according to Credit Suisse, a record month that also marked the third straight month that such “stripping” activity topped $5 billion.
Increased buying of zero coupon bonds from stripping has capped the rise in long-dated yields and helped flatten the yield curve, adding to suspicions that its recession forecasting abilities may be weakened heading into the next economic slowdown. Such concerns come amid public comments among senior Federal Reserve officials who wonder if the curve should have a role in guiding how fast the central bank should raise rates. An inverted yield curve, when short-dated yields exceed their long-dated peers, has preceded every recession after World War II.
“Several realities have diminished the predictive power of the yield curve and make the Fed’s worries about its slope puzzling,” Matthew Luzzetti, senior economist of Deutsche Bank, said in a June 7 note. Contributing to the yield curve’s weakening relationship with an economic slowdown, he cited pension fund buying as well as the Federal Reserve’s past bond-buying efforts and the central bank’s continued use of forward guidance, which have served to cap upside for long-term yields. Yields and bond prices move in opposite directions.
The gap between the yields of the 5-year note TMUBMUSD05Y, -0.12% and the 30-year bond TMUBMUSD30Y, -0.31% is at 28 basis points. The 5/30 spread is a key measure of the yield curve’s slope, near its flattest level in more than a decade, according to Tradeweb data.
“Strong stripping activity has generally contributed to the curve flattening,” said Jonathan Cohn, an interest-rate strategist at Credit Suisse, in a Monday note. He found this relationship has strengthened in the last three years.
Strong appetite for long-dated Treasurys among pension funds may explain why the 30-year bond yield has seen less selling pressure than its shorter-dated counterparts, keeping it relatively anchored. Even in periods when the long bond rallied this year, making them more expensive to investors, auctions for 30-year debt have attracted strong interest.
Currently trading at 3.12%, the long bond has climbed around 50 basis points since Sept. 8, a smaller jump than the benchmark 10-year note TMUBMUSD10Y, -0.25% which rose as much as a 100 basis points in the same period.
Economists tie the predictive power of yield-curve inversions to the tightening of financial conditions that they represent.
But if the curve flattening and inversion reflects pent-up appetite for long maturity bonds, eroding the term premium, instead of fears about a growth slowdown, economists’ recession models that employ the yield curve may prove less effective than before, said Luzzetti.
Read: An inverted yield curve is a recession indicator, but only in the U.S.
The term premium refers to the compensation investors demand for buying long-dated paper over their shorter-term peers if rates do not move as expected. Once an ever present feature of the bond market, the term premium has been negative since last March, according to the Fed.
Also check out: Yield curve’s return to flattest levels in decade raises question over its significance
Pension funds also need to top up on bonds for other reasons. Many of them still need to rebalance their gains in their equity portfolios last year toward bonds.
“Stock market outperformance has led to large flows into Treasury bonds from pension funds, as these funds seek to lock in equity gains and rebalance their portfolios. These fixed income inflows have contributed to term premium compression pressures,” said Luzzetti.
In addition, corporate treasurers have ramped up their bond buying to “take advantage of higher tax deductions,” said strategists at Société Générale. Pension plan contributions can be deducted at the old corporate tax rate of 35% before the September deadline, a move that would boost profit margins.
Fed researchers, however, have pushed back against the idea that this time is different. In a paper earlier this year, economists at the San Francisco Fed said suggestions that the historically low level of interest rates would make a recession less likely in the event of an inversion weren’t supported by their research.