Oil price slump could rock bond markets
DUBAI, 13 days ago
By Simon Fasdal
This could be a quarter that sees relative stability in global bond markets but a dive in the oil price or geopolitical risk could be the rock on which the steady ship founders.
Entering springtime and summer always brings in a certain kind of optimism, at least for us northerners, who at this point have struggled with darkness and freezing temperatures for five months in a row.
That optimism applies to financial markets too.
In fact our upbeat Q1 view entering 2017 has to a large extent materialised, Equities are on multi-year highs, inflation and growth have surprised to the upside, despite a never ending stream of political risk factors. In fact, the political risk factors, the European elections, could very well have a less-than-expected impact on markets, but a high degree of uncertainty in the run up to elections (planned event risk).
Global yields are also higher, and in line with our predictions, but this is where we believe things still need to unfold. We are disappointed at the level of global core yields, and therefore this is where we advise caution. However, for the moment, there are factors hindering the breakout of global yield from the present trading pattern, and why a move higher in global yields could be delayed or even compromised by below components.
Seen from a market perspective, the fear of elections in Europe is related to anti-EU protest voters forming governments that will further threaten to tear the EU project apart. That is the fear, and that is also why we expect a significant build-up of risk off up to the French election.
But even in the case of a ‘No’ EU government forming in France, there is a huge possibility that such a government will be deprived of real power. So we believe that the largest proportion of the political-related risk will vanish after the French election, making room for a relief rally in riskier assets, but also eliminating safe-haven premium in core markets like the German, Dutch or Danish bond markets, and sending the overall core-yield levels higher.
In September, the German election can restart another round of moderate risk off, although we do not see the same market concerns regarding this election, at this point in time.
Oil price crash
Oil prices stabilised in 2016, and the level around $50/barrel is positive for inflation components, as the impact of the huge drop to $27/b in early 2016, has been replaced by an increase in the oil price. This means together with other factors that inflation is picking up, and still will produce a modest base effect which eventually will send global-yield levels higher. On the other hand, a revisit back to the $20s/b level in oil, could see a significant impact on not only inflation expectations, but also bring back volatility on financial markets, with a knee-jerk reaction of lower equities and lower global yields.
Could there be another oil market crash? The problem is that despite increasingly higher demand projected on basis of higher global growth, the supply is still abundant and ever increasing, with the very adaptable shale oil market capping the market in any attempt to send oil prices higher.
Furthermore, taking into account the major positioning in the oil future market is also critical and could send the price into a downward death spiral, as any unwinding of the positioning will unleash a record high of potential oil future selling.
We do not see a tailrisk to markets, from current geopolitical issues. However, developments in Turkey could increase uncertainty in Europe, but with an expected small impact on markets. However a standoff in the Turkish political situation can create waves for the Turkish and generate spillover to other emerging markets.
So, despite our firm base-case belief that we will continue to see gradually higher yields throughout the year, and potential risk on rallies in riskier assets after elections, the above factors could change this.
If we do not see the expected positive development, some fixed income markets may trade too cheap at the present moment. In our view, markets linked directly to the dollar benchmark curve is on our radar and could easily deliver a bounty of returns, if the accumulated expectations on fiscal policies, higher global growth and inflation are not met. The US corporate bond market will benefit if we enter another round of lower global yields, and will become ripe for positioning, if the disappointment is confirmed.
EM = easy money?
Our year-long positive view on emerging-market bonds has been confirmed by significant gains in most major EM-bond markets. We still support this view entering Q2, and see the continued gradual improvement in major EM economies as having a stronger impact on the attractiveness of the asset class, than gradually rising global core yields.
One of the reasons for that is the moderate risk/reward premiums in the EM asset class, which we believe will continue to attract investors, as we see more and more EM markets becoming globalised, standardised and easier to trade and price against their developed-market peers. At the same time, several EM countries are becoming more mature and some of the quite risky early EM risk factors such as a lack of market structure/frameworks and market illiquidity disappear, as the economy and financial systems enter a more developed stage.
On the other hand, we do not expect 2017 to be a ride without bumps, and especially a build-up on Federal Reserve expectations or geopolitical uncertainty can bring in turbulence for the asset class. Also EM currencies are at risk of being challenged during 2017.
Political impact is overrated
The experience of political events during 2016 is that the market is reacting by building up expectations before these planned events. Typically risk is taken out of the market, and from a fixed-income perspective, core bonds often rally before the events on the back of this risk off positioning.
Often the positioning is due to large in scale funds that in many cases are forced to take down risk levels, due to internal or external risk models. The magnitude of the pre-event positioning has in two major cases been shown to be superficial, with significant relief rallies in riskier assets on the back of the event, even when worst-case scenarios unfold.
This is something to have in mind as we enter two major European elections with the same pattern of planned-event risk. On the bond side we are especially cautious on European core yields post the French election if it becomes a non-event, which is highly likely. The combination of improving European macro and higher inflation together with a European Central Bank under pressure to change course, could turn out to be an unhealthy cocktail for European bond markets.
We expect inflation and yields to gradually move higher, but risk factors to this scenario could arise from oil prices and geopolitical events. We also expect the elections in Europe to have a significant build-up of risk-off positioning, suppressing European core yields prior to elections.
The largest risk factor in bond markets are a potential post-election relief rally, that could drive European core yields higher more quickly than the market can absorb, especially if a less dovish ECB emerges after the election.
About the author
Simon Fasdal is head of Fixed Income at Saxo Bank, a leading multi-asset trading and investment specialist.