Update Bonds - market reaction to Iran war limited so far
All market participants closely followed oil prices this week, as energy prices are the main channel through which the Iran war can impact the global economy and financial markets. After all, higher energy prices result in higher inflation, which can lead to higher bond yields.
Oil production facilities, infrastructure and transportation are therefore key to watch, especially the possibility to ship through the Strait of Hormuz, which makes up around a quarter of total global seaborne oil trade and around a fifth of global LNG trade.
Despite the rapid escalation of the war with Iran this week, the impact on bond markets has remained limited so far. Brent oil prices rose substantially, but at around USD 80 per barrel (bbl), they should not hurt the global economy. 10-year US Treasury and Bund yields are bouncing up strongly, but this comes after a dip from safe haven flows late last week and therefore keeps yields within trading ranges seen in recent months. Credit spreads, so far, remain resilient and have not moved much. If the conflict can be resolved or contained in the next few weeks in a way that keeps the supplies flowing, we think markets are likely to look past this quickly. They would then refocus on the strong macroeconomic backdrop, potential impact from AI disruption and the challenges facing the private credit markets.
Nevertheless, this war does have the potential to impact markets more meaningfully if energy prices rise further and the situation does not improve within a few weeks. In scenarios where energy prices increase substantially, potentially reaching USD 100-130/bbl, depending on the damage to production facilities and disruptions in the Strait of Hormuz, bond yields could rise further in anticipation of higher inflation, while credit spreads are likely to widen substantially. For credit spreads, the 2022 invasion of Ukraine by Russia offers a useful comparison. That event pushed Brent above USD 120/bbl, and Europe faced a challenging situation regarding its energy needs. Back then, European credit spreads rose to over 220 bps for investment grade (IG) and over 660 bps for high yield (HY), compared to around 80 and 290 bps now, respectively.
We have an overweight in IG corporate credit, balanced by an underweight in HY where we view the expensive spread levels as most problematic. Should the war escalate and drag on, then we expect to see spreads widen which could lead to an entry point for HY.
Thomas Smid