Oil price not yet weighing on bond sentiment

Government bonds have once again shown themselves to be a safe haven during the recent market turmoil. Now, however, there may be clouds on the horizon for the bond markets according to Dirk Effenberger writing in the latest edition of UBS Investor’s Guide. The oil price has risen to an all-time high, but this is only likely to be bad news for bond investors if the price increase gains momentum.

Effenberger does not currently expect this to be the case. Amid the current credit crisis, investors have almost become used to the fact that falling equity prices are beneficial for government bonds. Declining prices on the equity markets have always pushed government bond prices sharply higher and thus sent yields lower. In the major markets of Japan, the eurozone, and the UK, yields on ten-year government paper have fallen by 40-60 basis points, while those in the US have plummeted by almost a full percentage point.

At the same time, the oil price has risen to a new record high. The price of West

Texas Intermediate (WTI) oil has climbed above USD 90 per barrel against the backdrop of renewed geopolitical tensions and below-average inventory levels, which equates to an increase of more than 60% over the year.

We might intuitively expect a positive correlation between oil prices and bond yields. Since rising oil prices usually mean higher inflation risks, investors increasingly seek

refuge in material assets such as real estate or gold. Demand for bonds thus falls, causing yields to rise. Under this assumption, rising oil prices should be bad news for bond investors.

Gradual oil price increases have little impact on bond markets In fact, however, the correlation during “normal” phases is relatively low because bond yields are influenced by a host of other factors as well. Examples of such factors in recent months have included the flight to safe investments, which pushed yields lower despite a steady uptrend in the oil price. Overall, increasing competitive pressure worldwide, the reduced dependence on oil as a production factor, and moderate pay agreements in the leading industrialized nations have helped to keep consumer prices under control over the past

few years.

“Our main scenario involves a continued normal phase in which oil prices do not accelerate. In fact, we expect a gradual easing on the back of an economic slowdown in the US, subsiding geopolitical tensions, and production capacity being freed up. We forecast that the average price of a barrel of WTI in 2008 will be about USD 70. Bond yields should thus be driven more by the economic outlook, which is why we expect yields at the long end to trend sideways in the months ahead,” writes Effenberger.

In the slowing US and UK economies, meanwhile, the downside pressure on interest rates is slightly higher than in regions where economic growth remains robust such as the euro zone and Switzerland.

Should credit fears ease, ten-year yields may even rise here over the short term. Only an oil price shock would have an effect A dramatic increase in the upward momentum of oil prices has in the past led to a rise in bond yields. Only in such cases have fears over inflation won out and noticeably dented demand for bonds. If geopolitical tensions escalate and production capacity falls further, we could see increased upward momentum in oil prices once again. A spike well in excess of USD 100 would probably result in significantly greater inflation worries.

Bond yields would rise, and bond prices would therefore fall. However, we think this scenario is extremely unlikely from the current perspective.

“Overall, we advise investors to keep a close eye on the oil price going forward. It is our view that bond investors have no justification at present for selling bonds solely on the grounds of the oil price increase.”