Financial market participants are grappling with several conflicting and puzzling trends. Commodity prices are scaling new peaks on a daily basis, yet inflationary pressures are virtually absent.
Led by the Federal Reserve, short-term interest rates have begun to rise, signalling the start of global monetary tightening. Instead of rising in the face of short-term interest rates, bond yields have declined sharply over the past three to six months. Meanwhile, the main foreign exchange cross rates and equity indices have traded in quite narrow ranges in recent months.
The table scopes out the key changes in commodity and financial markets since end-June. Top billing has to go to the oil price, which has risen by $16 over the period, a rise of 47 per cent. As yet there are few signs of any respite in this strong uptrend.
There has also been a clear trend in the bond markets, where the yields on 10-year government bonds have declined by approximately 50 basis points. Whilst not dramatic, this move in bond markets does count as a significant change in market direction.
In contrast, equity indices have been rangebound since the end of June, with no real discernible trend. The same is true in the foreign exchange markets, although the euro has begun to strengthen in recent weeks.
The reasons behind this downward move in long-dated government bond yields are the subject of intense debate in the investment community. The key factor would seem to be the emergence of the current soft patch in the US economy. Also, recent data for the UK and the euro zone suggest that European growth may be losing some of its momentum.
So far, higher oil prices have probably not been a major factor in the current slowdown. However, as time goes on the near 70 per cent rise in the oil price so far this year will have a deflationary impact on global growth.
Of course, higher oil prices will also exert upward pressure on inflation. However, it seems that, so far, the effect has been very muted. Core rates of inflation in the US and the euro zone are just under 2 per cent, indicating that high crude prices have yet to feed through to the main measures of consumer price inflation.
It would seem that intense competitive pressures are making it very difficult to pass on higher oil costs. The airline industry highlights the difficulties where some incumbent carriers have introduced fuel surcharges on airfares. However, the low-cost carriers have no plans to follow suit and, therefore, intense competition will make it extremely difficult for airlines to recoup higher oil prices through higher fares.
The story is similar across many sectors so that higher oil prices must be squeezing corporate profitability rather than pushing up consumer prices.
If this were in fact happening, we would expect share prices to decline. This has not occurred, although there is a high degree of uncertainty across equity markets.
Corporate profits are still rising and the majority of equity analysts' take the view that the surge in the oil price will not be sufficient to derail the global economy.
US Federal Reserve chairman Alan Greenspan, the world's most powerful central banker, recently stated that the higher oil price would slow growth but would not abort the economic recovery. The silver lining in the cloud for equity markets is the likelihood that the Fed will moderate further the already slow pace of interest rate rises. Most market participants expect another 0.25 per cent rise in the Fed funds rate before year-end. After that, the Fed may pause until the impact on the economy of higher oil prices becomes clearer.
As well as economic fundamentals, speculative activity is playing a part in current trends. In the oil market, hedge funds and other investors with short-term time horizons seem to be adding to volatility in a significant way.
There also seems to have been a renewed interest in the "carry trade", where speculators borrow dollars at low interest rates and reinvest the proceeds in higher-yielding long-term government bonds. In the first few months of the year, such positions were being reversed as speculators reacted to rising short-term interest rates. The subsequent selling pressure in long-dated bonds was a key factor in driving up bond yields. Since then, the loss of momentum in US economic growth has persuaded speculators that short-term interest rates may not rise much further and they have resumed the "carry trade".
The recent divergent trends in the bond and equity markets cannot go on for much longer. Ten-year bond yields can only decline significantly below 4 per cent if the global economy looks like tipping into a recession. In such a scenario, equity markets would fall sharply. On the other hand, if reasonably strong economic growth persists, equity markets should rise and, eventually, short-term interest rates will also need to be increased. In the latter scenario, investors would sell bonds leading to higher yields.
Investor takes the view that the latter scenario is more likely and, therefore, equity markets offer better potential than longer-dated government bonds.
