The Bond Markets Get Real

The morning of Tuesday, 15 March, saw two potential world-changing developments suddenly hit centre stage.

The first, of course, was our old friend, the ten-year US bond rate. It started the month around 1.7 per cent and clearly bond traders at that time were not taking the threat of inflation seriously.

Then, in the days that followed, bond prices started to fall and yields started to creep up. Then, traders began selling bonds at a faster pace and the ten-year yield jumped to 2.14 per cent.

It was clear that suddenly markets were at last breaking out of the Federal Reserve’s fairy-tale land to realise that interest rates would have to rise to counter US inflation -- it’s up to 7.9 per cent and maybe heading to 10 per cent -- and those rate rises would affect US and global growth. The sharp rise in US petrol prices had been a key creator of this sudden bout of realism in the bond market. Bond prices held despite the oil slump.

Markets can change but the clear signs are there that we are headed into an era of much higher interest rates which will be driven by bond markets.

Central banks that are out of touch, like our Reserve Bank, will be forced into reality. This is clearly an important development for all share owners.

And then, on the same day, we discovered that Russia was asking for China to supply arms to Russian forces in Ukraine. The US has not allowed MiG jets from Poland to fly the skies in Ukraine, so Russia has air power enabling it to bomb Ukraine to the Stone Age and to win the war that way.

But strangely, Russia, while bombing lots of civilian targets, hesitated from creating an aerial massacre that would have killed millions.

On the ground Russia has lost many lives, particularly of young reservists, and the weapons that the US and Europe have provided Ukraine, plus the determination of its people, has destroyed not only young Russians but led to the capture of huge amounts of weapons. China is looking to form a strong bloc with Russia but the US has explained to China that if it supplies those arms to Russia then it, too, will be the subject of embargos. Almost certainly those embargos would include Australian iron ore. China is hesitating and is seeking peace via the UN.

This new Ukraine chapter needs to be followed closely. It is one of those crucial moments in what is a very dangerous struggle. European markets are optimistic and perhaps they are right, but speculation is easy. In the next week or so the rubber will hit the road one way or the other.

Here in Australia our Reserve Bank is holding back interest rate rises until after the election but the higher US bond yields are already pushing up bank costs so those banks that don’t edge rates up in the coming weeks will catch up after the election.

As we have discussed before, normally banks increase profits in times of higher interest rates unless those higher rates trigger substantial bad debts. A two percent rise in interest rates will greatly damage new home lending, real estate prices would fall and orders for new dwellings would decline.

But bank bad debts will be insulated because a lot of Australians now have substantially increased equity in their homes and have accelerated their repayments. Those that have bought houses in the last 12 to 18 months are most at risk. But paying mortgage instalments is very close to the main priority of young couples so they will maintain payments as long as they possibility can. And given low unemployment, it would take a much greater rise in interest rates than two per cent to cause substantial bad debts.

Meanwhile, I have been fascinated at the lack of attention analysts and the media has given to the other side of the Brookfield-AGL takeover bid. (Mike Cannon-Brookes gets all the media attention but his equity in the bid is only about 20 per cent).

Most of the reporting has been about coal but in fact one of the greatest attractions of AGL to the Canadian infrastructure Brookfield group is the AGL power distribution business. Remember, longer term, electricity distribution will take huge market share from petrol.

Those in the industry say AGL’s operation is high cost and can be transformed into a very powerful unit in a market that is expanding rapidly. Prior to the Brookfield’s AGL bid, Brookfield took three important steps – first they bought half of the biggest power smart meter company, Intellihub, for $1 billion. Then, Intellihub agreed to put Telstra SIM cards into all Intellihub smart meters and, finally, Telstra agreed to make Intellihub its preferred supplier of meters in Telstra’s plan to become a major power retailer in Australia.

These smart meters do far more than just read meters. Knowledge of the detail of electricity consumption is going to enable power retailers to advise on electricity use maximisation and on the purchase of appliances, cars etc.

When Brookfield announced their bid for AGL there must have been feverish activity in the Telstra bunker. They needed to consider whether to do a deal with Brookfield and buy into the AGL electricity retailing operation should Brookfield win control of AGL. The poor management of AGL had been one of the factors attracting Telstra into power retailing but competing against Brookfield would be a different matter.

On the other hand, it is much cleaner to start an electricity retail business from scratch, particularly if you have a customer base around your phone operation.

As it happened the Brookfield bid was withdrawn because it was given a bad reception by AGL. But almost certainly they will be back, and Telstra will need to make a vital decision – whether to go into power retailing alone or in partnership with Brookfield.

Almost certainly, if there is a power retailing partnership then Brookfield will want to share in the future share of Telstra’s ‘internet of things’ network – a communication network that enables internet appliances to communicate with each other.

It will be an essential ingredient in the new power network that both Telstra and Brookfield look to establish.

Telstra shareholders need to appreciate that step by step their company is being transformed by Chief Executive Andy Penn. Telstra has a health operation and a 53 per cent stake in Telstra Ventures, which is funding a large number of start-up companies. There is clearly a chance that one of the ventures will be a bonanza but, in the meantime, Telstra is learning about some of the new cutting-edge communications technologies. If you combine health, Ventures and power retailing, you can see a very different Telstra emerging from the original company.