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Bonds, Oil and Yields

Oil prices, risk appetite and long yields have all rebounded lately. While the link between oil prices, risk appetite and German yields is there, its significance should not be overplayed. US yield developments are more important, but they will not translate into much higher German yields either. A near-term rebound higher in German yields should be seen as a buying opportunity.

Will higher oil prices translate into higher yields?

The correlation between oil prices and yields is far from clear. Higher oil prices lift inflation in the near term and with that also inflation expectations. An inflation-focused central bank like the ECB may pay more attention to the shortterm inflation developments, as it is concerned over the socalled second-round effects, which would support a positive correlation between oil prices and yields. The correlation should also be positive, if higher oil prices are an indication of stronger global growth prospects.

However, for oil importers higher oil prices also act as a drag on growth, which should support lower real yields, possibly also lower longer-term inflation expectations.

One could also argue that if oil price developments are due to supply-related factors, the correlation between yields and oil prices should be negative, as the higher oil prices are a clear drag on the economic outlook.

If higher oil prices are due to demand-factors, the correlation could more easily be positive, as yields and oil prices would both be driven higher by positive growth prospects.

Recently, the oil price has arguably been driven by both demand and supply factors. The ECB, in turn, has been very focused on the oil price and its impact on inflation. While it would be tempting to argue that the oil price is a big driver of yields, the reality is quite different.

The correlation between the German 10-year yield and the oil price (calculated from weekly changes over a 52-week window) has been positive lately, but only around 0.25, while the sign of the correlation has been both negative and positive in the past few years.

The correlation between yields and equity prices has been of the same magnitude. The correlation between US and German yields, on the other hand, has been much stronger and also more stable through time. In other words, US yield developments are a significant determinant of German yields – oil prices and general risk appetite less so.

Fed to guide yields higher…

The big guidance to long yields continues to come from central bank policies. The ECB did not offer big surprises last week, but the Fed has a good chance this week to build credibility that it will still hike rates later this year.

The market is not pricing in much more than a 20% chance of a 25bp rate hike in June, and a hike is not fully in prices even by the end of the year. Considering that US labour market developments have continued to be positive, global risks have not at least increased, the USD has weakened and the S&P 500 has risen back to around its highs, the timing for the Fed to take a moderately more hawkish stance looks good.

After all, the Fed can still postpone hiking as long as it wants, if the markets react too strongly to signals that another hike is approaching. What it really cannot do is hike rates when the markets are not pricing in a significant chance of higher rates, as it would mark a totally failed communication policy. In other words, if the Fed wants to keep the prospect of a June hike alive, it needs to guide the markets to price in a bit more.

…before the ECB drives them lower again

The ECB’s stance has not changed, nor is it about to any time soon. An easing bias remains, and the central bank will do what it takes to bring inflation back to its target.

The summer is approaching. Even before the ECB’s bond purchases, yields tended to fall during the summer months, as there was less supply and plenty of bond redemptions. This pattern is greatly intensified by the ECB’s EUR 80bn a month bond purchase programme.

True, there may be some front-loading of the purchases also this year, which would turn into slightly lower purchase volumes during the summer months. However, last year the frontloading was very modest, and in case it will be more sizable this year, it would only mean more downward pressure on yields sooner.

The bottom line remains that the ECB’s bond purchases will keep yields very low for a long time. In the coming months,the German 10-year yield is set to fall back, but will probably not breach the zero boundary. Any near-term move higher, potentially driven by a more hawkish Fed message, should be used to position for a renewed fall in yields.

Excerpt from Nordea Bank  Yields & Oil Report 23/04/2016

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