It all seemed to make a lot of sense to the media commentators this past week: government bonds rallied and equity markets fell because investors no longer expect a return of meaningful global economic growth during 2019, and in the UK the probability of a hard Brexit has supposedly surged because The Brexit Party won the most votes in the UK’s European elections. Taking a step back, both conclusions seem a little premature.
On the bond market side, yields have indeed fallen, which tends to indicate falling growth expectations and thus lower levels of expected inflation, for which investors expect yields to compensate. Recently however, inflation expectation changes have been closely correlated with oil price changes, which are not only driven by demand due to economic activity, but also by supply-side changes and by the ebb and flow of speculative demand positions. After the gradual rise in the oil price during the first four months of the year it has currently fallen back as Middle East tensions ease and the US shale oil producers increase their output. This price decline easily explains the recent fall in inflation expectations and thus the fall in longer term bond yields – if one is so inclined.