Why erupting ‘bondcano’ has investors rattled

There are potentially negative consequences for the entire market in the short term if bond yields rise any further.

Investors took cover this week in a falling market.

The benchmark S&P/ASX 200 index fell 1.2 per cent to a five-week low of 5295.5 points yesterday.

Of course the sell-off this week has been magnified by stock-­specific factors — Wesfarmers dived 2.7 per cent after Deutsche Bank cut its rating to “sell” on the back of a weak sales update a day earlier, putting pressure on Woolworths before its update today — and Commonwealth Bank fell 1.6 per cent amid a worsening financial advice fee scandal.

The Dreamworld tragedy has hit the tourism sector, with Mantra down 2.1 per cent yesterday, even though Dreamworld owner Ardent Leisure bounced 7.5 per cent on hopes the theme park would quickly reopen — expectations that were dashed by the police after the close of trading.

At least Crown Resorts stabilised after a two-week plunge on the back of China’s crackdown on the casino operator, and National Australia Bank rose slightly after maintaining its dividend.

But it’s worth noting that the “bondcano” is still erupting, with negative consequences for so-called “bond proxies” and potentially the entire market in the short term if bond yields rise any further.

The benchmark 10-year Commonwealth government bond yield jumped 6.6 basis points to 2.33 per cent yesterday, near the five-month high it reached last week. It was the biggest one-day rise in the so-called “risk-free rate” — often used to price equities — since September 12.

Given the magnitude of yesterday’s jump in bond yields — which reduces the relative value of equities — it’s no surprise that the ASX 200 share index suffered its biggest one-day fall since September 12. Back then, the index dived 2.2 per cent before hitting 5192.2 points two days later.

On the plus side in terms of valuation, forecast aggregate earnings per share has risen 3.5 per cent since mid-September, so combined with the fall in share prices, the rise in earnings estimates has pushed the price-to-earnings valuation of the Australian share market down to 15.5 times.

That’s the same valuation point at which the index bottomed in mid-September, and close to the same valuation point where the index bottomed in June (when the index hit 5051 points).

In terms of forecast dividend yield, which rises as the share index falls, the current yield projection of 4.6 per cent is also fast approaching the September and June extremes around 4.7 per cent.

So will the Australian share market bottom this week? If the bondcano cools down, it’s highly likely, but much will depend on German and US yields. ECB officials do have a lot of ability to cool the bondcano in the short term. All they have to do is keep pushing back on the bond tapering idea, as they have done since the Bloomberg story on this subject reignited the bondcano at the start of the month. However there’s talk in the market that Bundesbank officials are keen to signal an eventual tapering.

Certainly if bond yields rise any further, investors could require a higher dividend yield to attract them back to equities as an asset class, so in that case the market could fall further.

The technical target is the 200-day moving average at 5254. This moving average held in September. During the sell-offs of late 2015 and early 2016, investors only supported the market when the dividend yield rose to between 5.3 to 5.5 per cent and the PE ratio fell to between 14 and 14.5 times. The 10-year bond yield was peaking between 2.7 to 3.0 per cent at that time.

Funding costs in Australia are 50 basis points lower than they were at that time, and with policy and inflation thought to be on hold here, any further jump in yields probably has to come from offshore.

Looking at the German 10-year bund yield, 0.10 per cent is crucial on the chart, as a break there would easily trigger a jump to 0.30 per cent. That could push equivalent US Treasuries up to 2.0 per cent from 1.8 per cent now, pushing Australian 10-year bond yields into the 2.30-2.70 per cent zone. Note the major downtrend line on the local bond yield at yesterday’s close of 2.33 per cent.

For now though, investors should probably bet on the ECB cooling the bondcano.