Rates spark: Sentiment looking through geopolitical risks

Rate markets are still following the standard playbook, which means the higher oil prices are keeping inflation expectations and thus nominal rates elevated. Risk assets, however, seem to look through a revival of geopolitical worries, and Bunds do not seem to benefit from the return of market volatility.

Risk sentiment looking through surge in Oil prices already

Sentiment remains in a very optimistic mood and already seems willing to look through the latest setbacks in Iran. This week’s oil spike initially triggered some volatility in risk assets, but we see European government bond spreads tighter again and the VIX is also practically back to where it was before. Despite a nudge lower, oil prices still remain significantly higher than before, but this doesn’t seem to change the broader market outlook.

Markets’ inflation expectations also remain higher than at the start of the week as rates are following the standard playbook. Oil prices are directly linked to near-term inflation expectations and are thereby adding to the upward pressure on nominal rates, especially at the front end of the curve. We're bracing for more volatility going forward as oil prices react to new geopolitical developments. If anything, the risk seems tilted to the upside, because as long as the Strait of Hormuz remains under threat, supply constraints will start to intensify.

An important question is whether growth indicators will also react to the latest moves in oil. From an inflation perspective, the pass-through is obvious, but this time round, business sentiment might not be as sensitive to the latest headlines. If PMIs, for example, manage to continue recovering, then that would add to the upward pressure on rates. In effect, that would reassure European Central Bank members that taking a more hawkish approach may not be as damaging.

More effort needed to not have Bunds safe haven status challenged

While markets saw a brief risk-off moment, a common hedge for such a scenario has not performed well. At least away from the front end, Bunds initially even cheapened versus swaps, with the switch to a new benchmark also muddying the picture somewhat.

Since the start of the month, the news flow around Germany itself has been pulled in both directions, one could argue. On the one hand, the government’s reform drive seems to be finally gaining momentum, tackling important issues such as pension reform to ensure the long-term viability of its finances.

On the other hand, the government has increased its borrowing plans for the years through 2030 by another roughly €50bn, taking the overall net borrowing from 2026 through 2030 above the €1tr mark.

However, both developments are perhaps not quite as impactful as the headlines suggest. The borrowing plans were always surrounded by upside risks, especially on the back of macro headwinds posed by the geopolitical backdrop and the higher financing costs as rates increased. As for the reforms, rating agency Fitch has just commented that the reform push was “positive, but not transformative” and is “unlikely to materially improve Germany’s weak medium-term growth prospects or fully address deeper competitiveness challenges.” Here, markets are currently confronted with headlines that underscore the struggles of the influential automotive sector.

Looking at a set of various short and longer-term regression model approaches for the 10y spread over OIS, we see Bunds not particularly undervalued at the moment, on the cheap side but within one standard deviation and moving in line with other market risk indicators. The longer run still poses headwinds, though, with Germany’s structural issues, growing supply and ongoing quantitative tightening. On the latter, the recent quarter-end has shown indications of growing tightness in some corners of the short-term funding markets that will eventually lead to a more material rise in repo rates as the ECB’s bond portfolio melts off.

The latest headline that Japanese pension funds are encouraged to invest more domestically could also chip away at the demand side, though within EGBs it is likely to impact France more given the distribution of the funds’ holdings.

Read the original analysis here