How oil is causing bond yields to spike

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It all seemed so certain.

Market participants watched the yield on the 10-year German sovereign bund tick ever closer to the zero mark in April, all the time taking bets on when, not if, it would mean that investors would be paying for the privilege of holding German government paper.

But like many times before, market consensus got it wrong and the fixed income markets snapped back causing a reversal in global assets like major equity benchmarks and foreign exchange.

"These shifts run counter to many of our core views, as well as what were clear consensus positions amongst many of our clients," a team at Goldman Sachs Global Investment Research said in a morning note on Wednesday.

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Many are still in the dark as to what actually happened. Some believe that the European Central bank (ECB) might have slipped up in its bond-buying duties, causing the spike by leaving the market unattended for a matter of hours. But many see a growing debate about inflation as the real reason behind the move, with a resurgent oil price causing both stocks and bonds to move downwards.

The trifecta of moves – a stronger currency, rising yields and a falling equity market – had a coherent macroeconomic story about it, according to Goldman Sachs. This suggests that the market is questioning European policy commitment in an environment where inflation expectations are starting to inch higher, the bank said, which it adds could be caused by a recent climb in oil prices.

Fuel prices are a key ingredient to a basket of goods and services that make up inflation statistics in most countries, with oil being a major input in motor fuels and other manufactured goods. It can also impact on food prices as lower motor fuel prices reduces the cost of transporting goods. The Office for National Statistics in the U.K. has repeatedly highlighted the sizeable drops in the oil price and how that has weighed on consumer price data which has recently hit multi-year lows.

Oil prices rose to fresh 2015 highs on Wednesday morning on the back of slower output from Libya, a weaker dollar and data that showed a fall in U.S. crude supply. Brent crude futures traded higher at around $68.94 a barrel in midday London trading and U.S. WTI crude was higher at $61.77.

Meanwhile, 10-year German bund yields continued their reversal on Wednesday and hit a fresh 2015 high of around 0.547 percent. 10-year U.K. gilts broke above the 2 percent level on Wednesday morning and benchmark 10-year Treasury note yields traded around 2.19 percent Wednesday having touched a high not seen since March 10 on Tuesday.

Bond yields move with an inverse relationship to bond prices with the latter usually being negatively affected in an inflationary environment. Inflation means that a central bank is more likely to raise interest rates which reduces the demand for credit. If inflation is also particularly high it can also make holding debt securities less favorable as investors might losing money missing out on high-yielding assets like equities that usually perform well in an inflationary environment.

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Marshall Gittler, the head of global forex strategy at brokerage IronFX, is another that has emphasized what impact a higher oil price is having on the price of bonds.

"Yield curves around the world are steepening sharply," he said in a note on Wednesday. "That's usually a harbinger of stronger growth to come. In that case, why are equities down across the board, too? Perhaps the rebound in energy prices has something to do with it."

A rise in oil prices due to a reduction in supply would be bad for growth unlike a rise in prices caused by an increase in demand, Gittler explained.

"It could be that the markets are starting to sense mild stagflation – a recovery in inflation before a recovery in growth. That would be bad for all markets, " he added.