Having charged out of the three-month down channel in early May, German 10-year bunds yields have already exceeded most estimates of where they might trade this year. Talk of structural asset shortages and liquidity supply has given way with alarming speed to a market-to-market panic that has seen whole bathrooms thrown out along with babies and bathwater.
"As central banks withdraw market stimulus… selling in the bond market begets selling in parts of the equity complex."
The sell-off in Europe has helped push the US 10-year note yield up to new eight-month highs, closing in New York around 2.445 per cent. The US 10-year bond yield has increased by more than 80 points from the late January lows, with the prospect of the first Fed rate hike apparently alarming a generation of new traders who have never lived through a tightening cycle before.
Bloomberg recently used data from the Emolument.com salary comparison website to note around 30 per cent of Wall Street traders started in their roles in the last five years and the average age of a Wall Street trader was a surprisingly low 30. Bloomberg noted two-thirds of traders have never seen a full Fed tightening cycle.
The impact of the selling in the major fixed-income markets is hard to resist in Australia where the 10-year government bond future remains under pressure. Having enjoyed a relief bounce of 10 points the contract promptly gave up almost 12, before recovering 4 points off its lows after a speech from Governor Glenn Stevens this week.
The combination of lack of investor appetite in the longer end along with the possibility of further regulatory easing in the short end has caused the Australian bond curve to steepen significantly.
For most of the back half of last year the closely watched and heavily traded Australian three-year sovereign and 10-year sovereign bond spread traded between 60 and 80 basis points, before falling to a low around 45 in the first quarter of this year during the great global duration panic.
Since then the curve normalised back into the 60 to 70 point range before breaking higher in early May.
Interestingly the Australian curve didn't really correct lower even when bund yields moved back down later in May. The curve is however displaying a strong correlation with outright 10-year bond yields in the major markets.
With the short end rate anchored by the Reserve Bank of Australia this curve move is much as we would expect it to be. The curve position is acting much like an outright risk in the current environment.
The generally accepted perspective on banking stocks globally is a steeper yield curve is profit enhancing and bank investors own a better quality asset when the banks are able to earn more carry on their investment portfolios.
JP Morgan and a number of other US banks have indicated they expect their earnings to increase as longer dated rates rise in the United States.
The structure of the Australian banking system is somewhat different to the United States, and Australian mortgage lending is much less exposed to long-duration interest rate movements.
Antipodean mortgage holders tend to hold their mortgages for a shorter period of time, and some enter fixed rate contracts for relatively short maturity periods.
Despite those facts the banks still hold a significant book of bonds for both capital and liquidity purposes and we might reasonably assume they will earn more on those bonds as interest rates move higher.
As sensible as it might seem it's not being reflected in the price action as major Australian banking stocks continue to tumble. In the below chart the scale on the bond spread price is inverted. The bond curve price is represented by the White line, with the yellow line being the ASX banking index.
The correlation between the steepening of the Australian bond curve and the weakness in Australian bank stocks is not entirely coincidental, although the timing of the increased regulatory scrutiny on the Australian ban and the threat of additional capital requirements has occurred at the same time global bond markets have sold off.
More importantly perhaps is the relationship between bond yields and investment decisions amongst Australia's army of self-managed super funds.
This community in particular sought income shelter by owning the high-dividend paying stocks of the Australian banks in an environment where declining bond yields and cash rates left them unable to meet their retirement goals.
It's not clear as yet how much selling of these stocks have taken place by the SMSF community, but it does make sense as bond yields rise the attractiveness of bank dividend yields diminishes.
In many ways the doubling in the value of the Australian bank index that occurred between September 2011 and March 2015 was a direct result of global QE.
The actions of the world's global central bank's reduced the value of money, inflated the value of assets and caused a scramble for income paying duration assets that went far further than most observers ever assumed.
The arms of the global central banks are long and their influence reached all the way down to Australia, with tumbling government bond yields driving superannuitants into the equity market in an effort to safeguard themselves from the insidious forces of financial repression.
As global central banks start to withdraw their interest rate and asset market stimulus these trades go into reverse and selling in the bond market begets selling in parts of the equity complex.
This is an edited version of a report originally written by Triple T Consulting for Credit Suisse and is reproduced with their permission.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
29 Oct 2014