Rates Spark: Dancing to the energy market’s tune

European rates could have chosen a less volatile market than energy to follow the moves of, but such is the worry about European inflation. Whether the hope that above-target gas storage and energy market reform will actually durably deliver lower energy prices is a question we’ll leave to our commodity strategy colleagues. In the shorter run, the eye-popping volatility in energy markets is making short-dated rates and bonds even more difficult to trade.

By taking a leaf or two out of the Fed’s book, the ECB has encouraged this state of play. Rightly or wrongly central banks are increasingly reliant on backward-looking measures of inflation, and their fear of second-round effects means energy inflation has greater-than-usual relevance in their decision-making. This line of thinking should probably not be pushed too far but in the current market environment, this is driving even higher volatility in the rates market.

Interestingly, the fall in energy prices has offered much-needed relief to the euro bond market, but this failed to translate into a re-steepening of the curve. Month-end maturity extension flow probably bears some responsibility for the back-end’s performance but we see a more structural reason for a flat term structure, namely the deteriorating economic outlook. Barring a durable change in the trajectory of energy prices (and an immediate ECB change of tone seems unlikely), only the long-end is free to reflect Europe’s less-than-rosy economic outlook.

It is also possible that this sudden fall in energy prices is used as an excuse for position-squaring ahead of next week’s ECB meeting event. Anyone positioning for higher EUR front-end rates in August would have done well out of the recent move and has perhaps less to hope for in the difficult-to-navigate meeting. Until then, more traditional drivers of interest rates should reassert themselves. Borrowers issuing debt in these difficult markets should find that supply has a greater-than-usual impact on price action, with diminished market liquidity and lower risk appetite making a re-test of 10Y Bund yields above 1.5% a distinct possibility.