Oil shocks and geopolitics reshape outlook for fixed income

Conflict in the Middle East has complicated the near-term picture for fixed-income investing, says Dustin Reid, vice-president and chief strategist, fixed income with Mackenzie Investments.

Speaking on the Soundbites podcast this week, he said a lot of investment decisions hinge on how things develop in Iran and the broader Persian Gulf region.

And while there has been a recent trend of higher yields in fixed income — particularly in the U.K., Europe and some emerging market economies — that could easily be interrupted by escalations in global hostilities.

Reid said investors will be watching the region closely when evaluating riskier fixed-income assets.

“If you think that geopolitics will settle down over the next few months, and oil prices and energy prices broadly will settle down over the next little bit, then these global yields will probably come in — prices higher, yields lower — so, it’s a good time to be getting into fixed income,” he said. “But if you have a view that we’re not done yet, and we’re going to see a little bit more strife in the Middle East, and oil and natural gas is going to be higher for longer, then it’s not quite the time to get in.”

Either way, he said when the conflict inevitably passes, yields could be very attractive.

“It will be a very good opportunity to pick up some very good, higher-yielding assets, investment grade or just below investment grade assets in the emerging market space,” he said. “It’ll be very attractive for longer-term investors.”

Reid said global fixed-income markets will continue to be extremely sensitive to sustained higher oil prices.

“If instead of talking about US$100 oil, we’re talking about US$130 or US$150 oil, I don’t think the market’s quite prepared for that,” he said. “If we did see that, then I would expect further deterioration in emerging-market assets, and I would expect further deterioration in global fixed income. That would mean prices lower and yields higher. So that would be a challenging time.”

He added that a globally tight energy market with sustained higher oil prices would likely push the Canadian dollar to outperform other global currencies, including the U.S. dollar.

“If you see oil higher for longer, then it’s probably constructive for the Canadian dollar,” he said.

For much of this year, Reid and his team have been short U.S. duration in the 10s and 30s space. But with the recent move in oil prices and the war in the Middle East, they’ve covered their short U.S. duration position and are now slightly long duration.

“The idea behind that is that [with oil prices higher for longer], the market is going to stop trading the thematic of higher inflation, and it’s actually going to start trading lower global growth,” he said. “I think that we are close — although maybe a bit early — to flipping into that thematic.”

Reid also weighed in on likely paths for the Bank of Canada and the U.S. Federal Reserve as they consider interest rates this month.

He predicted the Bank is unlikely to change interest rates, noting that it appears to be more comfortable with domestic inflation — the recent surge in oil prices notwithstanding — and that it remains “somewhat concerned” about the labour market in Canada.

“Put that all together, and I don’t think the Bank’s going to be doing anything at the March meeting,” he said.

However, markets have started to price in the probability of Bank of Canada hikes later in the year.

“The market’s actually pricing about 25 basis points worth of hikes through the end of the year,” he said. “We still think that if inflation remains relatively well behaved, that the Bank would want to take advantage of cutting rates if it can.”

Markets are also pricing in 25 or 30 basis points worth of cuts for the Fed later this year, down from earlier expectations of about 60 basis points worth of cuts.

“The move higher in oil prices has generally been taken by the market as an inflationary shock, as opposed to a growth shock to start. And so, asset prices as well as central bank pricing has generally reflected that,” he said.

“The market’s starting to focus a little bit more on the June meeting now, which, in theory, will be the first meeting under the new Fed chair.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.