May 29, 2008 / 9:02 AM / 11 years ago

High oil's tax on growth could yet lift bonds

LONDON (Reuters) - The startling surge in crude oil prices in recent weeks has had the predictable effect of pushing up government bond yields, but fixed income investors may be about to take an altogether different view of how they should trade rampant energy costs.

Should oil remain at these stratospheric levels for a sustained period or rise even further, the potentially crippling economic impact could soon see bond yields lurch lower.

Rising inflation should be the reddest of red flags for bond bulls because it erodes the value of the fixed coupon investors get on their bonds, and boosts expectations of higher interest rates down the line. Bond yields move inversely to prices.

Equities typically perform better in a rising inflation environment as such episodes are usually associated with strong economic activity.

But as oil has soared up to $135 a barrel, sentiment toward stocks has soured as investors start to price in the damage to consumer spending and corporate profits from high energy costs.

With other commodity and food prices also at their highest in years, the darkening outlook for growth may be about to tip the slow growth-rising inflation balance toward a less bearish backdrop for government bonds.

“This rise in oil prices is more bad news for stocks and will be reflected in profit expectations. So the natural conclusion for bonds is that bonds will rally from current levels,” said Sarah Hewin, senior economist at American Express Bank in London.

“It’s slightly counter-intuitive. With inflation rising and price expectations picking up, that should be bad for bonds. But the damage that high oil price does to economic growth ... is an environment in which bonds rally.”

Crude oil has risen 12 percent so far in May to as high as $135.09 a barrel, taking year-to-date gains to over 30 percent. Although it has retreated sharply this week, the cumulative impact of soaring crude will have lasting effects.

And while bond yields have risen broadly since the middle of March, when the U.S. Federal Reserve helped coordinate JP Morgan Chase’s (JPM.N) buyout of stricken Wall Street rival Bear Stearns BSC.N, the back up in yields has been much greater on bonds of short maturities than longer-dated paper.

The difference between two- and 10-year yields shrank to almost zero last week from around 50 basis points in mid-April, representing a so-called flattening of the yield curve as investors moved to fully price in a rate hike from the European Central Bank before the end of this year.

The much more modest rise in longer term yields suggests bond investors, like their forward-looking counterparts in equities, are beginning to discount slower growth and an eventual tailing off of inflation.

CORRELATION BREAKDOWN

On top of the flattening of the yield curve since mid-April, a move often seen as a classic harbinger of economic slowdown or recession, recent correlations between the oil price and benchmark euro zone government bonds make interesting reading.

So far this year, the weekly negative correlation between crude oil and the benchmark Bund future has been around 67 percent. That means there’s a pretty strong inverse relationship between rising oil and falling bond prices.

By the same token, the correlation between oil and 10-year bund yields has been positive at around 50 percent.

But this month, with oil possibly on track for its biggest monthly increase since September 2004, those weekly correlations have broken down. The negative correlation with Bunds is a mere 5 percent and the positive link to 10-year yields is only 12 percent.

Figures this week showed that high energy prices are starting to bite in the euro zone. Consumer confidence for June in Germany, the 15-nation bloc’s economic powerhouse, unexpectedly fell and French consumer sentiment slumped to its lowest ever since the series began more than 20 years ago.

And still the inflation warning signs flash red. German state inflation in May jumped and inflation expectations measured by French and German index-linked bonds spiked to their highest in years.

French 10-year breakeven rates — the difference between yields on French inflation-protected bonds and benchmark Bund yields — popped up to 2.45 percent. Before the credit crunch erupted in August last year, the rate was around 2.05 percent.

German 10-year breakevens spiked up above 2.39 percent, marking a rise of more than 15 basis points in a week.

ECB Governing Council member Axel Weber told Reuters on Tuesday expectations of a rate cut this year was “wishful thinking” and 10-year yields hit their highest in five months.

Kenneth Broux, financial markets economist at Lloyds TSB in London, expects bond markets to remain under pressure as long as oil-led inflation remains a reality.

But he also accepts that it may not be so wise to automatically assume rising oil is an inflation, not a growth story. In that light, bonds may be in for a reprieve.

“Given that bonds are oversold, that’s a strategy worth pursuing. We’re being tested to the limit now, economies are being tested severely,” Broux said.

“You’ve got the ‘safe haven’ aspect which should support the front end (of the bond market) and the inflation aspect should see the long end (yields) drift higher and the curve steepen. But we’re not seeing that.”

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