The "tax twist" is a big deal

Here is how the “tax twist” worked.

Step 1: One trillion of US corporate profit repatriation. US tax reform resulted in all offshore corporate profits being “deemed” repatriated and relieved of future tax liabilities. This in turn resulted in a record-breaking 1 trillion dollar shift of US corporate earnings to their onshore entities. The shift had no currency impact – the liquidity was already held in short-dated dollar assets but merely recorded offshore from an accounting perspective. It happened all in one go in the first half of the year.

Step 2: US corporates liquidate their dollar deposits . One of the unusual features of this Fed hiking cycle has been rising money market rates over and above the increase in Fed fund rates. This can be most clearly seen in rising Libor – OIS spreads earlier this year. Part of this rise is attributable to the surge in treasury bill issuance. But spreads rose in commercial paper and front-end credit where most of offshore US corporate liquidity resided too. Just as the Fed started raising the risk-free rate, US corporates abandoned dollar liquidity. What did US corporates do?

Step 3: US corporate buybacks soar, the first twist. The bulk of corporate repatriation was deployed in equity buybacks. S&P 500 purchases have soared to the highest on record this year and we project will reach $800bn by year-end. To the extent that US corporate dollar liquidity was sitting unused in short-dated assets, this deployment of cash constitutes one of the largest risk transfers in the history of financial markets.

Step 4: Pension funds rotate from equities to bonds, the second twist. Our fixed income colleagues have documented the pension fund rotation dynamic well. US pensions are over-weight equities and stock out-performance this year has led to large liquidation of their holdings, in turn deployed into long-dated US bonds. This buying can best be seen in the record-breaking size of stripped treasuries, the preferred habitat of US pension funds. The surprising yield curve flatness this year can be mainly attributed to the pension phenomenon representing a price-insensitive removal of fixed income duration from the market equivalent to Fed QE.

Deutsche Bank