German bonds boost the Dax's style

European equities are higher today on the back of some general themes that are helping to sustain risk sentiment:

1, News that Russia and Ukraine are trying to reach a ceasefire agreement.

2, EU monetary support for European exporters hit by the recent Russian sanctions.

3, Low bond yields in Europe, helping to sustain demand for equities.

The development in the Russia/ Ukraine crisis is encouraging; however this is a very complex situation so we doubt that a solution will be reached overnight. We think a more potent driver of European markets this week could be bonds, especially for the Dax.

Last week German bond yields plunged. The 10-year yield fell below 1% for the first time in its history and the 2-year yield fell into negative territory. Since bond yields move inversely to price, German 10-year yields have become extremely expensive in recent months, helping to make the Dax, which has fallen 8% since peaking in early July, look increasingly attractive.

If you delve into the numbers, the Dax looks more attractive than bonds on a number of measures:

• The dividend yield is 2.90%

• The current earnings yield is 5.87%

The 10-year German bond yield is currently 1.0006% (at the time of writing), only 0.6% above the rate of inflation. Due to this, we could see larger investors diversify out of the German bond market and back into stocks, especially since yields could stay low for as long as the prospect of ECB-style QE remains on the table.

The technical view:

The Dax has managed to hold key support at 8,900, which was the lowest level since mid-March. It has been a bumpy ride the last few days as risk sentiment has taken a knock from geopolitical events. However, if risk sentiment can be sustained, and if central bankers at this week’s Jackson Hole conference can put to bed fears about early rate hikes, then the Dax rally could have legs.

A key resistance level to watch out for in the short term is 9,340 – the 38.2% Fib retracement of the June high to August low. If we can break above this key retracement level then it opens the way to 9,476 – the 50% retracement of the same move.

Takeaway:

• Record low bond yields are enhancing the attractiveness of the German Dax.

• The Dax has a higher dividend and earnings yield than German 10-year bonds.

• If yields continue to trend lower, particularly if the ECB embarks on a programme to ease policy further, then we could see a further decline in bond yields, and potentially more gains for the Dax.

• The first level of resistance is 9,340, the 38.2% Fib retracement of the June – August decline.