- Markets are under-estimating the effects of the oil price rally on inflation
- Bank of Japan, ECB and FOMC will be updating economic projections shortly
- Traders would be wise to position themselves accordingly
By Max McKegg
The US Treasury bond yield curve is steepening. G10 markets are playing follow the leader, except for Japan where the central bank’s new policy of “negative rates with yield curve control” has recently come into effect.
No one can put their finger on why rates at the long end are rising, although some tried to pin it on a ill-founded rumour that the European Central Bank was looking at tapering its bond purchases early next year. Certainly global rates won’t rise to any extent until the ECB and Bank of Japan back off their market intervention but that turning point may be closer than you think.
The horse may have bolted by the time the big three central banks issue their updated inflation forecasts over the next couple of months. Photo: iStock
The Bank of Japan will issue updated economic projections on November 1, the ECB on December 8 and the US Federal Reserve on December 14. In the three months since their last set of forecasts the oil price has rallied significantly
and this, combined with base effects, means that in each case the updated projections are likely to show headline inflation reaching 2% in 2018, if not earlier.
Bond market investors
, especially at the long end of the curve, are reading the tea leaves and pulling rates up, even as short rates remain zero bound. The tug-of-war between the long and short end is illustrated by the chart below of the 5-year US treasury yield (click to enlarge): rates are slowing moving up but are a long way from breaking out into blue sky above the resistance level.
The Fed giving an all-clear signal at its December meeting will give some impetus but the rally won’t get far unless the ECB and Bank of Japan indicate a willingness to take their foot off the QE peddle.
US 5-year Treasury bond yield 1993–2016
Here’s why they might do just that.
The Bank of Japan issued its last set of economic forecasts at the end of July, the ECB’s in early September. A key input into the forecasts was the oil price, and both used the futures curve as at the end of July/early August as their reference point. But as it turned out, that was a low point for oil, as shown in the chart below (click to enlarge). The result was that each set of forecasts assumed oil would gradually rise to around $51 by the end of 2018.
Source: Metastock. Create your own charts with SaxoTrader; click here to learn more
But Dec 2018 crude is now trading at $58. What impact will this new reference point have on the BoJ’s updated inflation forecasts due for release on November 1, and the ECB’s on December 14?
We can get some idea from the sensitivity analysis provided by the ECB, including an “alternative path” for the oil price. In the September forecasts, the ECB staff conveniently looked at a scenario that saw oil rising towards $58/barrel by the end of 2018. All else being equal, their model suggested this would add 0.1% to the 2017 baseline inflation forecast and 0.3% to the 2018 baseline. Therefore, if the oil futures curve holds around current levels, the ECB staff baseline forecasts in December are likely to show inflation in 2018 reaching 1.9%, “close to, but below, 2%” as mandated.
A similar 10% fall in EURUSD
would add another 0.1-0.2% in both years.
As for the BoJ, its current baseline forecast is for headline inflation to hit 1.7% during fiscal 2017 and 1.9% the following year. It doesn't provide a sensitivity analysis but, taking a line through the ECB, it’s probable the upward movement in the oil futures curve will justify the BoJ raising its 2018 inflation forecast to, and perhaps above, 2%.
Perhaps in anticipation of this, the BoJ’s new policy regime no longer includes a commitment to buy a certain amount of bonds each month, at whatever price the market sets. Rather it will buy (or in theory, sell) an amount needed to set the yield curve at a level most appropriate given the inflation outlook.
At the moment, that dictates yield on the 10-year JGB at around zero, but if inflation looks like it is going to be within sight of 2% in 18 months or so we can expect the BoJ to let the yield target move well into positive territory sooner rather than later.
Markets are under-estimating the impact the rising oil price will have on global bond markets and asset prices in general. The big three central banks will provide a timely reminder when they issue updated inflation forecasts over the next couple of months. But by then the horse will have bolted – markets don’t wait for the starting gun to be fired. Traders will be wise to position themselves in advance.
– Edited by Gayle Bryant
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.