GLOBAL YIELD: Crude Oil Presents Lurking Threat To Bonds
sg.biz.yahoo.com Wednesday February 19, 1:45 AM By John Parry Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--High crude oil prices, not far off 29-month highs near $37 per barrel Tuesday, present a lurking threat to longer-dated bond prices; a danger that sovereign debt's robust safe-haven bid amid fears of war is serving to obscure.
"If we didn't have the global risk premium (associated with war and security threats) that is giving Treasurys a bid and if we were to look in isolation at higher oil prices, Treasurys would probably sell off because of the potential inflationary impact," said Paresh Upadhyaya, currency analyst, with Putnam Investments in Boston.
Longer maturities are particularly vulnerable to rising price pressures, although such pressures would have to be sustained in order to markedly erode the price of such bonds, fixed income strategists point out. Bond yields and prices move inversely.
In order to have a marked effect on prices in the economy as a whole, crude oil would have to remain in its current high ranges for the next six- to 12 months, says Ihab Salib, a global bond portfolio manager with Federated Investors in New York.
That would tend to rub off more negatively on European government bonds than on U.S. Treasury bonds, because European economies are more susceptible to hikes in global crude prices than the U.S.
Yet any disruptions to oil supply that may occur if an U.S.-led war against Iraq takes place should be short lived, allowing oil prices to descend to around $25 per barrel within the next few months, leaving longer bonds relatively unscathed, Salib expects.
Federal Reserve Chairman Alan Greenspan is among those who expect the surge in crude oil and gasoline prices to be transient. Last week, Greenspan said that colder-than-normal weather in the U.S. has pushed oil prices higher, along with geopolitical uncertainties in Iraq and an oil strike in Venezuela, but added that eventually, "the fundamentals are for much lower prices."
Ignoring The Inflation Threat
Nonetheless, some economists fret that capital market participants are too heavily betting one way - on a swift U.S.-led military action in Iraq that would soon deflate any price pressures in the oil market - and are not paying enough attention to the off chance of any war becoming drawn out and hugely expensive.
"Markets are not pricing in a wide variety of scenarios, and are ignoring inflation" as a threat, said Lara Rhame, senior economist with Brown Brothers Harriman in New York.
"Everyone is taking for granted that there will be a short-lived, decisive military action and after that...oil will come back down, the dollar will be up again, stocks will be up again and businesses will be reinvesting." But this is only one of several potential outcomes, Rhame emphasizes.
The dollar has been punished over the past few months in anticipation of a war, while U.S. stocks hit multi-month lows and crude oil surged last week.
For now, global bond market participants "are looking at higher energy prices as a negative tax, which will slow (economic) growth, and be positive for sovereigns in general," said Jack McIntyre, global fixed income analyst with Brandywine Asset Management in Wilmington, Del.
And even should crude oil prices remain high for a sustained period, if the pricing pressures they stoked acted principally to cap global economic growth, that lackluster economic scenario likely would depress bond yields, some bond strategists argue.
However, there is another scenario that could prove treacherous for longer dated government bonds; that of so-called "stagflation": lackluster economic growth, but with rising price pressures. The emergence of that troubling phenomenon could present a real threat to longer dated sovereigns, strategists warn.
"If there are higher oil prices for some time, that could undermine any global recovery," perhaps sending some major industrialized economies into recession "which would also be bad for global equity markets," said Upadhyaya of Putnam Investments.
If stocks weakened, that would tend to send more shifts into shorter-dated government bonds - a classic refuge for investors when equities slump. But longer-dated government bonds could fail to tap these flows, at the same time suffering from rising U.S. federal government budget deficits and spiraling price pressures.
"Longer dated Treasurys are looking like less of a safe haven than they did a year ago when we didn't have these massive budget deficits and higher oil prices hanging over our heads," said Rhame of Brown Brothers Harriman. Rhame expects longer dated Treasurys yields are set to rise and more acutely than those of shorter maturities, resulting in a so-called `steepening of the yield curve'.
Rising government deficits may also put some upward pressure on euro-zone government bond yields, as major economies including France, Germany and Italy struggle to keep their respective deficits within the 3.0% of gross domestic product limit stipulated by the Stability and Growth Pact. Inflation does not present an immediate additional threat to longer-dated European sovereigns, but longer-than-expected oil price hikes could change the picture.
-By John Parry; Dow Jones Newswires
john.parry@dowjones.com; 201-938-2096