Bond mutiny sees equities thrown overboard

What is going on in the bond market? The FOMC was pretty much bang in line with expectations. Plus all ten voting members approved the statement – the first time this has happened since June – suggesting the Fed is moving as one.

Source: Bloomberg

Here’s the bottom line from the statement: The December and January statements were fairly similar. There was a slightly stronger stance on employment (as you would expect), which was described as ‘strong’. Growth descriptions were also more positive, with activity expanding at a ‘solid’ pace rather than ‘moderate’ – there are two hawkish view there.

The doves, on the other hand, got this from the outlook on inflation: The committee saw inflation ‘declining further’ below the longer-run objective rather than ‘continuing to run’.  It was also noted that inflation ‘declined substantially in recent months’ on the back of the collapse in oil prices, meaning inflation will continue to undershoot in the short term.

There is a bit for everyone in that statement. It shows at the very least the earliest move on rates will be June – this should have been good for equities and bonds. However, the reaction in the bond market was bizarre. The longer end of the curve moved down as bonds rallied, suggesting longer-term inflation expectations are falling – which is not what was described in the statement.

I am scratching my head as to why the ten-year rallied 10 basis points on the back of the statement. The ten-year yield is now 1.71% and has seen 54 basis points come out in the last month alone. Now I see the moves in bonds probably stem from traders soaking up yield. However, it shows that the market is happy to buy yields that are already super depressed to avoid buying risk in the equity markets.

That point is made clear in the US 30-year which is now paying 2.29%. The yield has fallen 52 basis points in a month to a new all-time low. Think about that… That’s lower than Australian cash rate and it’s a 30-year bond.

What does this mean? Return on capital is king, meaning yield investment is the only place to store your cash. If you want clear equity examples: Commonwealth Bank of Australia now has a net yield in the 4 handle and is still making record highs, while Telstra is also in the 4 handle on its net yield and is at 13-and-a-half-year highs.

However, another possible reason for equities being thrown overboard last night comes from what’s happening on the other side of the Atlantic.

Greece’s ten-yield bond added 84 basis points in a single day, reaching 10.08%. That’s a lot for any government bond. However, it’s the action in the three year-bond that is dire for Greece. The three-year added 270 basis points for a yield of 16.72%. There is a Greek tragedy in the making here.

The bond market suggests that it’s going to default or get the boot from the eurozone. There are whispers from Germany that if Greece alters from its current path, it’s curtains for their place in the monetary union, yet its new government would suggest it has a mandate to do just that.

Ahead of the Australian open

Like the FOMC minutes, Australia’s fourth-quarter CPI had a bit for everyone. Headline inflation was low at 1.7% - below expectations and well off the Q4 2013 read of 2.3%. The RBA doves were championing this figure as a clear path to a ‘certain rate cut’ Tuesday.

I’m not so sure. Volatility in the read was up and fuel inflation fell 6.8% in the fourth quarter while accommodation was up a similar amount.  The trimmed mean figure, which strips out these volatilities (and the figure the RBA concentrates on to make its inflation estimates), was actually stronger than estimated at 0.7% on the quarter and 2.25% year-on-year. That should be just enough to hold the line next week. However, I do believe the statement around ‘a period of stable rates’ will go, paving the way for rate cuts in the first half of 2015. I think this is likely to be March and May.   

We are calling the market down 59 points to 5494 as iron ore continues to freefall. Delivery into Qingdao hit US$63 a tonne and there looks like no let up here. Energy stocks in the US got a further touch up as oil production numbers from the US reached another high – supply continues to outpace demand. The energy space is currently no place for longer-term investment and I would suspect the Australian energy space is in for another high single-digit percentage sell-off today as day traders have a field day with the risk in this part of the market.

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