Fundamentals and yield differentials with US sovereign rates remain unfavorable for oil prices
Despite the agreement reached by OPEC, several factors continue to point to a downward trend in oil prices at the end of the year. In terms of carry trade (arbitrage between rate differentials), two factors support this trend:
(1) US sovereign bond yields are rising due to significant sales of Treasuries by the Chinese, Saudi, and Japanese central banks and heightened expectations of a Fed Funds rate hike in December.
(2) Weak carry trades on the oil price curve, with long-term prices below spot prices, creating a negative differential. As a reminder, one of the best investments in 2016 has been the oil price curve (+20% this year).
In fundamental terms, an OPEC agreement would help slow OPEC production and thus increase the price of Brent/WTI crude oil. Saudi Arabia would be willing to reduce its production to January levels if Iran froze its own. The effectiveness of this agreement would also depend on geopolitical developments in Nigeria and Libya, which have so far contributed to a reduction in supply. On the other hand, overall production growth would continue due to the increases announced in Iran (production target for the end of 2016 revised upwards), Venezuela (new drilling programs), Iraq (agreement with partners for an increase in 2017), and Russia (resumption of production). Coupled with persistently high barrel inventories, fundamentals are likely to slow the decline in prices without, however, creating a demand differential capable of causing prices to rebound in the medium term. Finally, net speculative positions remain bullish, exceeding the level seen in August when the price of Brent rose 20% to USD 50. The potential for a correction remains significant, despite the latest agreement reached by OPEC on Wednesday, September 28.
Effectiveness of Japan’s QQE « under Yield Curve Control »: risk of a decline in yields…at 10 years
The Bank of Japan announced its « QQE under Yield Curve Control » program, which targets a yield of 0% on 10-year Japanese government bonds. In addition to the beneficial effects on pension fund profitability through the flattening of the Japanese government bond yield curve, as mentioned in the minutes, this measure:
(1) reinforces an already favorable environment for more fiscal spending through debt,
(2) paves the way for a more favorable environment for yen depreciation in the event of a Fed Fund rate hike in December: the rate differential would necessarily increase as the Japanese rate would remain unchanged. Finally, a key question concerns the effectiveness of the policy of targeting a 10-year yield of around 0%. Markets are expecting a steepening of the curve on maturities of less than 10 years. The risk of steepening would be twofold:
(1) that the Bank of Japan would buy more maturities of less than 5 years, thereby crowding out private investors, which would lead to an increase in demand for longer maturities.
(2) that the steepening of the curve encourages investors to seek ever longer maturities (better yield differential), which would also increase demand for 10-year bonds. If both of these points were to apply, it would become difficult for the Bank of Japan to avoid a correction in Japanese 10-year yields, even though the target is 0%.
