The signals from oil, bonds and inflation

Jeremy: The global economy is still growing, but markets are turning more cautious. Bond yields have risen sharply across major economies, energy markets remain exposed to disruption in the Middle East, and inflation risks are building again. That leaves central banks with a difficult question: hold, tighten, or look through another energy shock?

So, what are the markets telling us right now? Are higher bond yields signaling inflation risk, concern about government debt, or a lasting shift in the cost of capital? And what does the oil market tell us about the risks ahead?

For South Africa, these global forces matter for inflation, for interest rates, the rand, and investor sentiment.

Hello, I'm Jeremy Maggs. This is No Ordinary Wednesday, Investec's podcast on what's shaping economies, markets, and business.

For our quarterly global update, I'm joined from London by Economist Ellie Henderson and Head of Commodities Callum Macpherson, both at Investec UK. Ellie, Callum, a warm welcome to No Ordinary Wednesday.

Jeremy: Ellie, let's start then with the broadest signal. What, in your opinion, is keeping the global economy resilient despite higher energy prices, tighter financial conditions, and this ongoing geopolitical risk?

Ellie: You are certainly right that the global economy has been fairly resilient despite the challenging backdrop. I think from a global perspective, we'd really point to three key factors that have been supporting activity. Firstly, there's been clear evidence that companies have front-loaded manufacturing orders, supporting the production sector due to concerns over potential supply chain disruptions in the future stemming from the conflict in the Middle East. Secondly, despite higher borrowing costs, AI investment has continued at a rapid pace, and that's really been supporting those economies that are directly integrated into the AI supply chain, such as the US with the data center build-out and South Korea with the production of memory chips. And I think the last point really relates to that AI story in that we wonder if there's been a bit of a wealth effect from the AI boom and the associated rise in stock markets around the world, with consumption in many developed economies have improved largely resilient.

Jeremy: Callum, oil markets do remain tight, but futures still point to lower prices further out. Perhaps you could tell us what the market is telling us about what happens next.

Ellie: Well, the front contracts, so prices for immediate delivery of crude oil, has increased quite sharply over the last couple of weeks as tensions have risen once again. And currently, there appears to be no real sign of any dialogue between the US and Iran that might resolve the situation.

So, the physical supply of oil remains tight, and the market's reflecting that in the front end of the curve rising. At the time of recording, on Monday the 7th of September, this is around getting on for $100 per barrel. That's close now to the August high, which was $102 per barrel. But still quite a bit below some of the levels we saw earlier in the war of $120 or so per barrel.

If we look further forwards, though, so the average price for 2027 as the forward curve that the futures are telling us is now around $80 per barrel, and that's also been increasing again. And so, it does point to some form of disruption dragging on well into next year.

Jeremy: Ellie, an energy shock does not automatically mean a lasting inflation problem. So, let's test this then. Where is the line between an energy shock that central banks can tolerate and one that would then force them to act?

Ellie: That's a great question. It's something that we get asked quite a lot in terms of, well, the central bank raising interest rates isn't going to open the Strait of Hormuz. It's not going to mean that the trapped oil and gas in the Gulf is going to be released, boosting supply and pushing down on wholesale energy prices.

But what the central bank is doing is that it's essentially making a judgment on whether this spike in wholesale energy costs now is going to lead into longer-lasting inflationary pressures at the one-to-two-year horizon, which is where policy decided now really has an effect because there is a lag between policy changes and the impact on the real economy.

So, what the central bank will be looking at is whether, firstly, these price rises are contained to energy, and secondly, it'll be more concerning for the central bank's point of view is if they lead to higher wages where households successfully negotiate higher pay to compensate for the higher energy prices, which are adding to the cost of living.

Now, for me and you, higher wages are certainly a good thing. However, for a central bank targeting inflation, it could lead to a wage price spiral leading to more entrenched inflation. And if we see some signs of that, then the central bank would certainly want to act to guard against it.

Jeremy: So, you talk about the impact on the real economy. What specifically then should we be looking at in the short term to determine whether energy inflation, as you allude to, is spreading into wages, into services, and those broader inflation expectations?

Ellie: So, we monitor a whole load of data, both official and private sources. At the moment, particularly if we talk about the UK, there are a few signs that it is spreading beyond the first energy scope. For example, if you look at core inflation, which excludes food, energy, alcohol, and tobacco, that hasn't shifted too much.

And if you then look at private sector regular pay growth, which excludes bonuses and typically has the most direct link to inflation, that's tracking below what the Bank of England would estimate is a pace of wage growth consistent with the 2% target.

And we look at those wage growth numbers and the core inflation growth numbers across economies. But what policymakers will be aware of is that this data can turn quickly, and they will want to be nimble and flexible to react if it does.

Jeremy: Callum, are prices currently being determined then more by loss of supply, by inventories acting as a buffer, or just by weaker demand responding to higher prices?

Callum: Well, it's a combination of those things. The underlying problem, of course, is a loss of supply or limited supply due to the conflict that's going on. The market has to then adjust to that to try and set prices sufficiently high that demand can come into some sort of a balance with what's available, bearing in mind that inventories are finite and have been drawing down.

And that equilibrium is constantly changing as views about whether this conflict might end sooner or later evolve and also modulated by the degree to which shipping companies are able to get some energy out of the Strait of Hormuz or not.

Jeremy

So, what tells you then more about the condition of the market? Is it the headline Brent price that you've already referred to, or the prices of other sources of energy?

Callum

Well, I think the key things are refined products and natural gas if you want to get a true impression of what's going on and its implications. So, although there has been some success in getting oil out of the Strait of Hormuz, and particularly the Saudi's East-West pipeline, which can transport around seven million barrels per day, so that's around 7% of world supply or something of that order, into the Red Sea, thus avoiding going through the Strait of Hormuz, has helped a lot, but that helps for crude.

The problem is where refined product's concerned, so things like diesel, jet fuel and gas oil particularly, the world market for them relies on refinery capacity that is inside the Persian Gulf, and that capacity is currently inaccessible or, or very difficult to access.

And on top of that, there's pressure stemming from the war in Ukraine because Ukraine has become increasingly effective at targeting Russian refineries. And so, the consequence of this is we're seeing, whereas we're talking about Brent maybe coming back to $100 per barrel, we've got diesel heading more towards $200 per barrel.

And it's a very similar story with natural gas. Before the war started, natural gas in the UK, for example, was trading at around 80 pence per therm. The price for this winter is now at 180 pence per therm, so more than 100% higher than when the war started.

Jeremy: Ellie, back to you. Long-term government bond yields have risen across the United States, the UK, Europe, and Japan. Now, is this mainly about inflation? Is it about fiscal risk or a more permanent repricing, do you think, of the cost of capital?

Ellie: Yes, the rise in sovereign bond yields is something we've been monitoring quite closely, and we saw quite a rise in the first half of last week. I think it's a mixture of factors that are all hitting us at once, which is pushing yields higher.

Inflation is certainly one of those factors. When you see an escalation in the conflict in the Middle East, then you are seeing yields rise as well with that. However, we don't think that inflation is the only thing at play here. If you split yields into real and break-even yields, actually real yields are rising as well, which does suggest that there's more to it.

We think, as you said, fiscal concerns are definitely part of it. We had a data point a few weeks ago that showed the US national debt has now exceeded 40 trillion US dollars. Now, these looming debt loads aren’t something just the US is suffering with. We're seeing it across Europe, Japan as well. And so, we think that's pushing yields higher.

But we also think there's a crowding out effect. Now, Economics 101, you talk about crowding out, and that's a case of the public sector crowding out the private sector. But we do wonder whether the vast amount of private AI issuance is actually impacting the sovereign bond market as well, weighing on prices. Prices move inversely to yields, pushing yields higher.

Jeremy: Ellie, we know the Fed, the ECB, and the Bank of England are all facing different versions of the same problem. Let me ask you this, which central bank do you think has the hardest decision over the next couple of months, and why?

Ellie: I think it's safe to say I don't envy any central banker right now. You've got central banks across the world facing threats to their credibility because inflation has been above target for so long. In the UK, the US, we're around five years now, while policymakers, they're also trying to navigate this world where external shocks are coming from all angles, and it's preventing inflation returning to target.

But out of the central banks you mentioned, I think it's probably the Federal Reserve that is facing the most difficult decision, particularly at the upcoming meeting. They're also trying to navigate all of this, but as well protect their independence, so it's another avenue to navigate.

And we saw last week President Trump once again say that he wanted lower interest rates, which is not necessarily right for the situation. So, I think the Fed is a difficult one to navigate based on the macro fundamentals, but also some other external pressures.

Jeremy: Callum, back to you. Without making a call on the direction of prices, what does sensible commodity risk management look like when the range of plausible outcomes is unusually wide at present?

Callum: It's a very difficult call for consumers at the moment. If you consider an airline, for example, that is considering when it should do its hedging for, say, the summer of 2027, it would currently have to do that at a much higher price than it did last year. But at the same time knows that if something did change in this conflict, and it might happen quite quickly, that somehow the Iranians, or the Americans come to an agreement or one side just throws in the towel or, or whatever, the market could very quickly become over-supplied and prices could fall quite dramatically.

 Okay, we know that there's going to be need to rebuild inventories, but nevertheless, prices could fall dramatically. So, somebody hedging now has the risk of that happening. But of course, if they don't, and so far, there's been an inclination for consumers to hold on and avoid hedging, what they've now found is that the price has gone higher, and delaying that decision has been expensive.

So, I think the only thing you can do, I mean, that sort of history tends to suggest that over time, that just keeping going and doing a bit here and there to average in the rate is probably the only thing you can do when you have really no idea what the future holds.

Jeremy: Ellie, higher long-term yields raise the hurdle rate for investment. So, what does this environment mean for companies making capital allocation and financing decisions, let's say over the next 12 to 24 months?

Ellie: Well, the risk backdrop right now isn't exactly supportive of high levels of investment. If you take the Middle East conflict, it's not clear at all where this will turn. As Callum said, things can change very quickly.

It's certainly plausible that there's been lots of back-channel conversations going along, negotiations that we're not aware of, and a resolution arises tomorrow, pushing borrowing costs lower. But on the other side, it could also escalate again, pushing borrowing costs higher.

That makes it very hard for corporates to plan big investments, as they don't know in what league borrowing costs could be or the macro backdrop that they're faced with. In the UK, you also have the uncertainty because we have Chancellor Healey's first budget on the 28th of October, which could see some big changes to fiscal policy.

So, it's a hard backdrop for corporates.

Jeremy: I want to finish this conversation by testing the base case with both of you. And Ellie, let's stay with you. What's the risk scenario that would cause you to make the biggest change to the global outlook over the next quarter?

Ellie: It's certainly the evolution of the conflict in the Middle East. In our base case right now, we have assumed a swift resolution to the conflict that allows the Strait of Hormuz to open. It allows oil and gas out of the Gulf.

However, it's very plausible that also that this conflict lasts a lot longer than we have assumed. You know, we thought it would be weeks at the start. We're now at the six-month stage. But both sides do have an incentive to come to a resolution.

In the US, you've got midterms around the corner and Iran is feeling a great degree of economic pain from the sanctions.

Jeremy: And Callum, in a similar vein, rather than giving us a commodity price forecast, what's the one indicator in the physical energy market that you're going to be watching to tell you whether conditions are genuinely normalising or becoming a lot more difficult?

Callum: I would be looking at the premiums of things like diesel over Brent, because at the moment we have a situation where Brent is trading close to 100, diesel is trading $100 per barrel over that at $200 per barrel, and these are very unusually wide spreads. It'd be much more usual for that spread to be sort of $20 per barrel, $15 a barrel, or something like that.

So, when we see that start to come down at the short end of the curve and further out into 2027, that's when we'd start to believe that the market is looking in better shape.

Jeremy: And finally, as we draw to an end, one from each of you. When we meet again for the next quarterly update, Ellie, to you first, what's the single economic or market signal that you think is going to matter the most?

Ellie: Well, for us, I don't think it's a traditional economic data print like inflation or a particular market move, an interest rate decision, or a commodity. It's probably actually Truth Social posts.

All of our forecasts come back to the evolution of the Middle East conflict, as we previously spoke about. And the way President Trump communicates is through Truth Social. So, I think we'll be refreshing that constantly, as we have been over the coming weeks and months.

Jeremy: And Callum?

Callum: Well, for me, it's the flows of actual physical energy, whether it's oil, gas, or refined products. Because ultimately, the market is driven by how much energy is able to flow, and that's really the key thing.

I mean, whatever Trump says, whatever the Iranians say, you know, Trump can say that the Strait of Hormuz is open, but if no ships are passing through it, then so far as the energy market's concerned, it's closed. And so, it's really the energy flows that count.

Jeremy: And that's where we are going to leave it. Ellie Henderson, Callum Macpherson, thank you both for joining me on this edition of No Ordinary Wednesday.

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