Global Weekly: The Middle East and the oil price

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Iranian Quds Force commander Qassem Soleimani was killed in Iraq by a US drone attack on Friday 3 January. The Iranian retaliation came on Wednesday, when a few rockets hit sand dunes next to a US military base in Iraq.

President Trump responded by tweeting “All is well”. A sigh of relief followed and markets bounced back. The oil price fell to levels last seen in mid-December 2019. Both sides have incentives not to engage in a direct confrontation and US President Trump has called for negotiations with Iran, but we expect the conflict is far from over.

Iraq’s parliament voted to expel foreign troops from the country, but whether this vote will be enforced is still up in the air. The Iraqi government has not voted on it yet. Moreover, the US has threatened Iraq with sanctions against its oil exports if it proceeds to expel US forces, and this could be a game-changer. Not only would it be ironic as the US tried to safeguard Iraq crude exports during all previous crises at all costs, but with 4% of global production, it would also take a serious bite out of global supply.

As long as geopolitical tensions do not result in actual production disruptions, we judge that any upward pressure on oil prices will prove to be short-lived. Market pricing suggests that the stress of possible supply constraints is anticipated to have an effect only in the very near term. Due to the global production oversupply – despite an OPEC production cut – and ample global inventories as well as strategic oil reserves, there will be no shortages of oil in the near term.

Bonds: History often rhymes

Back in December 1998, an article in the NY Times was headed „Impeachment vote in House delayed as Clinton launches Iraq air strike, citing military need to move swiftly”. It is easy to make a link to US President Trump’s recent ordering of the drone attack on general Soleimani in Iraq.

The current air strike, however, may have more serious consequences than the one ordered by Clinton more than 20 years ago. The 10-year Treasury yield briefly touched a low of 1.705% in response to the military action, to then rebound to sub 1.90%. There is some room to move to the key resistance line at around 1.96%/2.01% if the global-growth recovery story resumes.

Core inflation data which will be released next week should convey the clear message that inflation is near the Fed’s target, but is not expected to overshoot in the near-term. The aforementioned level for 10-year Treasury yield can be considered a cap for the time being. The joint signature on the “phase-one” deal on 15 January should not attract much attention from bond markets, but the uncertainty about “phase two” will probably keep yields contained.

In Europe, it is once again all eyes on Italy. Until 12 January, the Italian Senate can call a referendum on a law that reduces the number of senators and members of parliament by one third. This might increase tensions, though this is not our base case.

Two regional elections on 26 January, one in Emilia Romagna and the other in Calabria, will also be closely observed by market participants. Italian government bond spreads should therefore remain volatile over the next couple of weeks. Tensions within the government could rise rapidly if the opposition party wins the upcoming regional elections and the number of members of parliament declines due to the referendum.

Doubts also remain in Spain, where it remains to be seen whether the new government coalition is stable enough to complete a full term. Nevertheless, spreads in Spanish sovereign bonds should resist to any significant widening caused by Italian politics.

Hence, further developments in European peripheral countries should keep Bund yields at (very) low levels, despite some signals of a resuming economic recovery in the eurozone. We keep our relative overweight of Spanish over Italian government bonds.