The bond markets have been devastated by oil. Put another way, you can't help but wonder if the ayatollah didn't short the bond market. For over the past three months, while the dollar has performed admirably against the currencies of our major trading partners, the world bond markets have performed miserably.
Let's look at the facts. We will focus on the relationship of the dollar to the currencies of Japan, West Germany and Britain; on the yield changes in those countries' 10-year government bonds and on the change in yield spreads of their 10-year government bonds compared with the 10-year U.S. bond. The period under observation is May 1, 1987 to Aug. 5, 1987.
The U.S. dollar has appreciated over that period, 8.4 percent against the Japanese yen, 5.7 percent against the German mark and 6 percent against the British pound. Remember when the dollar was weakening earlier in 1987, the U.S. bond market declined in price.
Over the period in question, yields on the 10-year bonds of Germany rose 87 basis points, of Japan gained 222 basis points and of Britain increased 67 basis points. Concurrently, yields rose 55 basis points on the 10-year U.S. government bond.
As far as the yield spreads between the 10-year bonds in the various markets (which measures the degree of attractiveness of one market compared with another), they changed as follows. Germany went from a spread of 260 basis points in May to the current spread of 228 basis points. The Japanese spread moved from 527 basis points to 360, while Britain went from a negative 183 basis points to a negative 95 basis points.
This means that in May, a Japanese investor could have gained 527 basis points more yield by investing in the 10-year U.S. bond rather than in Japanese 10-year bond. Today he would only improve his yield by 360 basis points.
In short, the worldwide bond markets have sold off to such an extent that the U.S. government bond market (even in the face of a strengthening dollar) is not as attractive a place for foreigners to invest now as it was in May.
The basic change which caused this uproar in the bond markets has been the 13 percent increase in the price of oil from May to August. In effect, the rise in commodity prices, including gold and silver, along with the Persian Gulf crises of the last several weeks, has given investors the perception that inflation was on the rise and that interest rates would continue to seek higher levels.
In reality, the price of oil and the direction of the bond markets are being held hostage by the unforeseen and unpredictable actions of Iran. In that context, it would seem reasonable to assume that one of two events will occur. If the flow of oil is disrupted in the Persian Gulf, the United States appears committed to keep the oil flowing. So in time the price of oil should decline. Or, if nothing happens over the next four to six weeks, the price of oil should decline anyhow.
James E. Lebherz has 28 years' experience in fixed-income investments.