The Overnight Report: The US Bond Conundrum

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By Greg Peel

The Dow fell 101 points or 0.6% while the S&P lost 0.5% to 1888 and the Nasdaq dropped 0.7%.

It appeared as if the initial stock market reaction to the budget was set to be negative yesterday when the ASX 200 plunged over 20 points on the open, but in fact it was just Westpac, NAB and Macquarie going ex-div to the value of 20 points. The fact the index closed almost flat on the day suggested the budget rated around a 20 point rise, perhaps on the “could have been worse” trade, although there were the usual non-fiscal influences to consider.

In the end there was a bit of sector shuffling, with healthcare the loser and engineering & contracting a winner while consumer discretionary posted a gain, suggesting a balanced impact on retailers from the various budget pluses and minuses.

The highlight of the day came from Commonwealth Bank ((CBA)) which, after providing another solid quarterly update, saw its shares trade over the $80 mark for the first time in history. Never mind that just about every bank analyst equity strategist in town has been calling all of the Big Four, and CBA in particular, overvalued on a low growth trajectory all year, or that Moses was the first to call CBA’s premium to the other three unwarranted. The FNArena database shows only two Buy ratings for CBA, with three Holds, three Sells and six red faces.

The underlying reality is that if you can trade at your all-time high while still offering a 5% fully franked forward yield on double-A credit rating and back that up with robust earnings then you are an attractive investment in the post-GFC world, domestically and globally (even without the franking). And this, funnily enough, provides us with a segue to the ever more perplexing conundrum of why US bond yields remain stubbornly low and why, to everyone’s astonishment, yields in the likes of Spain, Italy and Ireland are not much higher. Indeed, French yields are lower.

Is the French economy a better risk than the US economy now? Are the economies of Spain and Italy almost as safe a risk as the US? Hardly.

The ten-year bond yields of both the US and Germany were around 1.4% two years ago. The US yield is now at 2.54% on an improved economic outlook. Germany’s is at 1.37%. Germany’s economy has also improved but Germany is carrying the can for all of the eurozone. On weak eurozone inflation, the ECB looks set to introduce QE very soon. Hence the German yield remains low and the yields of the other major eurozone economies are trading at risk-spreads to the bund which reflect the fact any ECB stimulus floats all boats.

Meanwhile, the Fed is tapering QE. This should imply higher rates but there are three factors to consider: (1) is the US economy really as strong as many assume; (2) how far can the Germany-US spread realistically widen to; and (3) is there something else at work here?

Yes there is something else at work. The developed world is ageing and retirement considerations are becoming more and more fundamental. The GFC both shocked anyone over 50 into suddenly worrying about retirement income and scared many off stock market investment for good. Yield is required, government bond yield is safe. The more adventurous can pick up better yield in the stock market, but will only consider safer bets. They would be the likes of stalwart blue chips, healthcare, utilities and – you guessed it – solid offshore opportunities like CBA.

What’s happening in the US right now? The blue-chip Dow hit a new all-time high before the broad market S&P did. Investors are looking for “value” (safe yield) and eschewing risk (momentum, small caps). Last night the Nasdaq dropped another 0.7% and the Russell 2000 dropped another 1.6%. Both have wiped out Monday’s brief relief bounce.

And last night the US ten-year bond yield fell 7 basis points to 2.54%. The share market was gobsmacked, because last night the April PPI was released showing wholesale inflation jumping 0.6% when only 0.2% was expected, to an annualised rate of 2.1%, up from 1.4% only two months ago. If inflation goes up, so too should bond yields, given inflation undermines the value of fixed interest investment.

Now, it was mostly a headline rise, with the core PPI (ex food & energy) rising only 0.3%. And there is some scepticism given the PPI calculation was rejigged at the beginning of this year. Tonight we’ll see whether increased wholesale inflation is passing through to increased retail inflation with the April CPI release, which is not a given, particularly if retailers are forced to cut margins due to lack of demand. But whatever the case, US bond yields should not be as weak as they are unless something else is the driver.

Meanwhile, the UK economy has been the stand-out star of the last twelve months yet last night the BoE governor suggested the UK economy is still not strong enough to justify any thought of a rate rise for some time. (The UK ten-year, incidentally, is at 1.9%).

The US PPI shock at least affected a US$11.40 jump in the gold price to US$1306.10/oz, despite a steady US dollar index, given when it feels like it, gold can be an inflation hedge. The Aussie dollar staged a delayed reaction to the budget in rallying as high as 94 late yesterday, but has drifted to be up 0.2% over 24 hours to US$0.9379.

I posed the question last week as to just how high nickel can go before a correction, only to see it fly to the moon again this week. Until last night. There was no news, but someone decided it might be about time to book some profits and started selling. The crowd soon cottoned on, and nickel fell 6%. Where did the money go? Well all the other metals, except tin, were up around 1%.

Spot iron ore rose US50c to US$103.50/t.

The oils were again stronger, with Brent up US82c to US$110.14/bbl and West Texas up US36c to US$102.06.

With Wall Street coming off its new highs as US bond yields fell, the SPI Overnight is down 23 points or 0.4%.

SingTel ((SGT)) and SP Ausnet ((SPN)) will release full-year results today, Graincorp ((GNC)) a half-year and Paladin Energy ((PDN)) a quarterly.

Watch out for that US CPI tonight.

Rudi will appear on Sly Business at noon and again at 7.30pm on the Switzer Report.
 

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