Bond yields continued their move higher this week. The move lower in the second half of May has now been revealed as a brief downward correction against an ongoing rise in yields. On Monday, US 30 year bond yields moved past the early May high of 3.12%, closing last night at 3.21%. The Australian 10 year yield also began to inch past the recent high of 3.05% in yesterday’s trading
Australian bank shares famously benefitted from the yield chase caused by very low bond yields but this party looks like its over. Although, the Fed has not yet begun to lift rates, bond markets are not waiting around for it to dot the i’s and cross the t’s. With the writing of higher rates on the wall and fears of deflation receding, bonds are being sold and their yields rising well in advance of any move by the Fed.
The current sell-off in Australian bank shares has been mainly about markets positioning for this “normalisation” of bond yields.
The key questions for bank shareholders are now going to be just what “normal” turns out to be for bond yields and what that will mean for the market valuations of bank stocks.
The question and answer session of RBA Governor Glen Steven’s speech yesterday included an interesting discussion on the first question. Mr. Stevens noted that rates are likely to be considerably lower than the pre GFC average for some time to come. Former US Treasury Secretary and widely respected economist, Larry Summers recently suggested, for example, that the coming Fed tightening cycle would see its rate peak at around 2.5% with the next easing and QE cycle starting from around that level.
So it seems possible that the new normal for bonds could be something well below the pre GFC historical averages for some time to come. Timing is as usual another major consideration. While there is a general global adjustment underway in bond markets at the moment, there will be ultimately differences in the timing of central bank moves to adjust cash rates. This morning’s cut in New Zealand’s cash rate is a reminder that in this neck of the woods, central banks still have an easing bias while the Fed is looking forward to tightening.
US 30 year bond yield chart
So what light can the charts shed on these issues
The chart below includes a couple of pattern based projections which I will be watching as potential targets for the long US bond yield.
On the immediate horizon is a possible ABCD pattern consisting of the swings labelled in capital letters. This cuts in close to the 61.8% Fibonacci retracement level around 3.3%. Here the CD swing would be 127% of the length of the AB swing. 127% is a commonly used Fibonacci ratio
A second alternative is up around 3.5%. Here CD would be 161.8% of AB. At this level the more recent swings labelled in red would also be equivalent i.e. ab=cd. Certainly a 3.5% long bond yield would seem consistent with a scenario where the Fed rate was making a very gradual ascent towards 2.5% with the long term inflation rate around 2%
I've shown this yield chart to make it a bit easier to compare prices. However, bonds are traded in prices and that's the way they appear on our Next Gen plaform. Rising yields mean falling prices.
Commonwealth Bank Chart
Commonwealth bank shares closed about 17.5% below their March high yesterday. Shareholders will be considering if this adequately reflects the ongoing move to higher bond yields.
PE values can be a useful tool for make a rough comparison between today’s prices and historical valuations. Based on forecast current earnings, CBA’s, price: earnings ratio peaked at around 17.2 times in March. Yesterday it closed around 14.4 times. In the 2 years leading up to the GFC it averaged 14.9 times. During this period the Australia’s 10 year bond yields averaged 5.8% compared to 3.05% yesterday. Given the banks’ lower growth prospects now compared to the pre GFC years there’s an argument to say they should be valued at lower PE values. Broadly though, historical comparisons suggest that the lion’s share of the adjustment for normalization of bond yields has already occurred and CBA’s share valuation is already back towards a sustainable long term level.
These levels are only approximate and markets can over shoot. A couple of potential support levels on the CBA chart below may be worth watching. These are the 78.6% Fibonacci retracement level around $78.50 and the October low around $73.50 If the market falls to (and shows signs of stopping at) either of these levels they may represent an opportunity to buy CBA at reasonable long term valuations.