Crude suggestion

Feb 1st 2007
From The Economist print edition

There may be an ominous link between oil and bond prices

WHEN stockmarkets fall precipitately, the story makes the nightly television news bulletins. But sudden moves in bond prices rarely attract anything like as much attention, even though the fixed-income market plays a vital economic role, setting the borrowing rate for governments, companies and homeowners.

So people can be excused for not noticing the recent tumble in American bond prices, which had driven yields sharply higher before a slight recovery on January 31st. On that day, the ten-year Treasury bond was yielding 4.83%, almost half a percentage point above its level at the beginning of December (see chart). The 30-year yield, until a decade ago the world's benchmark, was close to 5%.

The obvious cause for the change in mood is the American economy and the policy stance of the Federal Reserve. At the start of December most people thought the Fed would cut interest rates in the first half of 2007, in response to an economic slowdown. But recent data have been stronger than expected, causing most economists to push back their expectations of rate cuts.

However, the bond market is a lot more complex than you might think from the simple mantra of “rate rises bad, rate cuts good”. For a start, bonds can operate as a kind of negative-feedback system; when yields rise, so do mortgage rates (particularly in America, where loan rates are linked to bond yields). Higher rates damage the housing market, and thus the broader economy, a development that can send bond yields back down.

Then there is the complex relation between bonds and oil prices. In the 1970s higher crude prices simply meant rising inflation, which was bad for bonds. Nowadays, thanks in part to sounder monetary stewardship, the relationship has reversed; higher oil prices mean a weaker economy, which is good for bonds.

The oil-bond nexus has acted as a thermostat for the global economy. Higher crude prices restrict demand, cooling the economy down. But the resulting lower bond yields then boost consumer confidence, heating the economy up again. And, as in recent months, falling oil prices (good for consumers) have been accompanied by rising bond yields (bad).

The linkage goes further. When oil prices rise, money flows into the coffers of the producers. Some believe this has helped push bond yields down, because the petrodollars are invested in American Treasuries, much as Asian countries invest their surplus savings.

But pinning down a direct correlation is tricky. Barclays Capital points to a clear connection between oil prices and holdings of Treasury bonds by the Organisation of the Petroleum Exporting Countries (OPEC). But an IMF study* has found few links between oil prices and ten-year Treasury yields, and a paper** by Raman Toloui of PIMCO, the fund management group, suggests an indirect relationship at best. He shows how oil exporters have recently been amassing reserves faster than Asian governments have—last year, he estimates that they generated some $500 billion of reserves, against $284 billion in Asia. Much of this surplus ends up in central banks, or in government outfits like the Kuwait Investment Authority. Mr Toloui reckons that every $10 rise in the price of crude brings oil exporters an extra $90 billion-100 billion a year. Their assets add up to at least $1.5 trillion.

It is not possible to get accurate data on where all this money has been invested. But Mr Toloui reckons that some 40% can be pinned down. The vast bulk (two-thirds) is invested in bank deposits and short-term securities. Only 3% is put into long-dated American Treasuries.

So that would not, at first sight, seem to suggest that oil money has been driving bond yields up and down. Consequently, there should be little reason to fear that lower oil prices will remove a big buyer from the Treasury-bond market.

However, it may be that oil money flows into Treasuries via an indirect route, for example through fund managers acting on the oil nations' behalf. And even if an OPEC country invests its reserves in, say, Japan, that only gives the Japanese more money with which to finance the American current-account deficit.

Americans may, therefore, have just cause for some concern about their bond markets. The oil exporters do not appear to be as keen to buy dollars as do Asian central banks—which want to control their exchange rates to ensure their exports remain competitive. And even Asian nations, such as China, are talking about finding new ways of investing reserves.

In the long run, this could mean that Americans would have to pay more to finance their current-account deficit—a bearish sign. The recent rise in bond yields could be a first step in that reckoning.