Fixed Income  

Keep on expecting the unexpected

This article is part of
Fixed Income Investing - January 2016

As the oil price touches 11-year lows, there are few signs that the price can significantly recover.

Opec appears in disarray, there’s still too much supply, geopolitical tensions between Saudi Arabia and Iran are not helping matters, and there are concerns about global economic growth.

Inflation is a difficult variable to predict and, in the past couple of years, it has always been low compared to the consensus among economic forecasters.

This opens up potentially interesting opportunities on both the upside and downside in terms of the oil price and inflation levels. Inflation-protected markets globally have priced in almost no recovery in inflation expectations. Indeed, the market has extrapolated the recent drop in oil prices to long-dated inflation expectations – effectively saying oil prices will stay low for 10 years.

In Europe, inflation is expected to take more than 30 years to return to the 2 per cent level. So long-dated inflation breakeven rates are extremely low, because the inflation market is completely out of fashion. Any significant bounce in the oil price would lead to an immediate rise in inflation breakeven rates, particularly as these rates have fallen to recent lows.

Were the oil price to fall to the low $20s, on the other hand, it could have significant implications for other asset classes. US credit markets, with their relatively high weighting to the energy sector, might underperform. But there are other potential losers, such as banks that specialise in lending to the energy sector.

This year could be all about supply and demand for fixed income. As economies continue to expand and budget deficits gradually fall, many countries have less need to issue bonds.

Fixed income bulls point to this reduction in supply, along with the presence of big buyers like the European Central Bank (buying €60bn a month, every month, until March 2017), as a reason why bond yields may be underpinned around current levels. So in net terms, after taking account of redemptions, the supply of euro-area government bonds will be negative.

But the picture may not be so rosy. Many emerging market countries are having to sell portions of their reserves to support their economies or protect their currencies. These are generally held in either US dollar or European bonds, and liquidating these holdings will put upward pressure on bond yields.

This effect could be compounded by markets anticipating the end of European quantitative easing (QE). If the ECB gives no signs of extending its QE programme, markets will, by the start of the third quarter of 2016, start pricing the withdrawal of the ECB as the biggest buyer of euro-area sovereign bonds.

After relatively skinny returns in 2015, some investors may re-allocate away from fixed income benchmark funds and more towards alternative sources of income. If this occurs against a backdrop of a reasonably strong economy and higher inflation, investors will demand a higher yield to invest in government bonds.