Bond and oil markets diverge on an end to the ceasefire.
- In response to the end of the ceasefire, bond yields have spiked, while oil prices have remained low
- Oil has fallen from $90 to $74 per barrel, yet US Treasuries have remained steady at 4.57%
- It suggests either that yields should drop, or oil should spike
Bond yields were an early casualty of the war in Iran. Yields spiked higher as oil prices rose in a pattern that continued for the duration of the conflict. Yet yields have not come back down in spite of a significant drop in the oil price. On news that the ceasefire is over, bond yields have spiked and oil prices have not. Who is right?
David Roberts, head of fixed income at Nedgroup Investments, says: “We’ve seen a breakdown in correlation between oil and bond pricing. One month ago, oil was $90 per barrel. Despite the news today, it is $74 per barrel. US Treasuries were 4.57% a month ago. They are back to 4.57%.”
The gap looks anomalous. Bond yields should be rising because the market anticipates higher inflation. The main cause of that inflation would be higher oil prices. If the oil price is stable, those inflationary pressures should not materialise. In the UK, the 10-year gilt was 4.2% at the start of the war. It hit 5.2% at its peak, and had fallen back to 4.7%, but is now back up again to almost 5%. It is a similar position for US Treasuries.
It suggests either that yields should drop, or oil should spike. Which one will happen will depend on the next steps by US policymakers. There are talks in Qatar, but both the US and Iran have issued strikes in recent days and the situation looks fragile. The bond markets appear to believe that the war is back on, while oil markets believe it is still over.
However, as Roberts says, it also suggests that there is a lot of bad news priced into bond markets. Bond markets may have been too optimistic about rate cuts earlier in the year, but now they appear excessively pessimistic about rate rises. In the UK and Europe, inflation has been undershooting and there have been few signs of contagion from higher oil prices in the rest of the economy. Inflationary problems are more pressing in the US, but bond markets seem to be treating all countries the same.
The bond market is supposed to be the sober, cautious element in global financial markets, but has behaved slightly hysterically at various points during this crisis. It may be a problem that governments have too much debt – and bond investors have too much choice – which creates greater fragility.
