Macro

Market Reversals: What to Make of Them

March 13, 2015 | By Nick Sargen

Highlights

  • The past few weeks have witnessed reversals from trends of the past 12 months in European bond yields, the value of euro versus the dollar, and the price of oil. We investigate the factors contributing to them and assess whether they are likely to be sustained.
  • The spike in European bond yields appears to be a correction to markets that had become significantly over-valued after the European Central Bank (ECB) launched its quantitative easing program at the beginning of this year. That said, the situation is very different from the "taper tantrum" that occurred in the U.S. two years ago, as the ECB is committed to buy massive amounts of bonds at least through September of 2016.
  • At the same time, the euro has firmed against the U.S. dollar amid weaker-than-expected economic news in the U.S. and diminished expectations of Fed tightening. However, we believe the softening of the dollar will be temporary.
  • The rebound in oil prices of $15-$20 per barrel for West Texas Intermediate and Brent crude may stem from diminished supply in the U.S. However, U.S. oil production could increase later this year if prices stay at current levels, which would renew pressures on oil prices. In any case, we do not foresee a continued rise in oil prices this year.

Spike in European Bond Yields

Over the past few weeks European government bond yields have spiked by 50-75 basis points, with the 10-year German bund yield rising from a record low of 5 basis points to as high as 80 basis points. It is currently trading around 70 basis points. According to economists at J.P. Morgan, this is one of the largest and swiftest sell-offs of bunds during the Economic and Union Government Bond (EMU) era, and it appears to reflect an unwinding of positions that investors put on when the ECB embarked on a massive bond-buying program at the beginning of this year.

Nonetheless, while some observers are likening the sell-off to the "taper tantrum" that occurred in the U.S. bond market two years ago, the circumstances are very different: The surge in U.S. bond yields then occurred as the Fed announced it was contemplating phasing down its quantitative easing program, whereas the ECB is still in the early stages of its QE program, which is slated to last through September 2016.

The most likely explanation is that the rally in European bonds had simply gone too far, with short-intermediate yields in many European government bonds falling below zero. Whereas investors previously feared Europe was headed for Japanese style deflation, two developments have lessened these fears: (i) The eurozone has emerged from a mild recession in 2014, and (ii) higher oil prices have lifted headline inflation rates and inflation expectations throughout the region. In addition, the spike in yields may be linked to diminished liquidity in European bond markets.

The question remains, how much further are European bond yields likely to rise? Our view is the eurozone economy is likely to gain traction in response to oil price declines and a weaker currency since mid-2014, as well as improved financial market conditions throughout Europe. Therefore, we view the trend in European bond yields as higher, especially with yields in many countries still near all-time lows. However, we do not foresee an added spike in yields the remainder of this year, considering that economic growth in the eurozone is expected to be modest - 1%-2% per annum - into 2016 while core inflation is likely to remain low.


Softening in the U.S. Dollar versus the Euro

The back-up in European government bond yields spilled over to the U.S. bond market, where the yield for the 10-year treasury has increased by 30-35 basis points to about 2.25% in the past two weeks. At the same time, the U.S. dollar has softened by about 5% against the euro, after having surged at one point by nearly 25% since mid-2014.

The main impetus behind the dollar's easing is diminished expectations about U.S. economic growth and Fed tightening in 2015: The preliminary estimate for real GDP growth in the first quarter of 0.2% at an annual rate is expected to be revised to a negative number in the wake of a larger-than-expected deterioration in U.S. trade in March. However, it appears the data once again is distorted by a severe winter, and that some of the deterioration in U.S. trade was influenced by a West Coast dock strike. Our call is that the economy will strengthen in the balance of this year, as it did one year ago, as consumers spend more of their windfall from lower oil prices and domestic producers of oil stabilize capital spending and possibly expand production in the second half of this year.

Meanwhile, we do not look for the dollar to strengthen immediately, as investors do not expect the Fed to tighten monetary policy anytime soon. However, the markets will respond to incoming data just as Fed officials do, and expectations could change quickly once the economy regains momentum, especially if the unemployment rate continues to decline. Therefore, we view the dollar's recent softening as a temporary development and look for it to test parity versus the euro later this year.


Firming in Oil Prices

The third key market development has been a firming in oil prices of $15-$20 per barrel in the past two months, with the price for West Texas Intermediate currently hovering about $60 per barrel versus a low of $42. The upturn in oil prices does not appear to be demand-driven, as global growth in the first quarter was unusually weak and China's economy slowed noticeably.

The more likely explanation is that oil markets are responding to cutbacks in oil production and capital spending in the United States: The rig count in the United States has fallen more than 50% from its levels in mid-2014, and domestic oil producers have cut back significantly on capital spending plans. As forward prices have strengthened, however, some domestic producers are contemplating stepping up their production later this year. Therefore, we think the most likely outcome is that oil prices will fluctuate within broad ranges: Thus, higher prices will induce increased production, which, in turn, will have a subsequent dampening effect on prices. In our view, the key factor that will limit future price increases is the reluctance of Saudi Arabia, as the residual supplier of oil, to cut back on its production. Therefore, we do not foresee further material price increases this year.