Threatened U.S. military action in Iraq and ongoing tensions in Israel could push up oil prices further--as high as $30 per barrel--causing corporate credit spreads to widen. Though oil is not a dominant factor in the European market, slow economic growth and high inflation combined with high oil prices could bring spreads under pressure, says Geraud Charpin, credit strategist at BNP Paribas in London. Good sentiment toward corporate bonds is largely a result of expectations of a sustained recovery that will underpin credit quality and support demand. An oil crisis could jeopardize that recovery, says Charpin. Autos will likely be most affected by high oil prices. "If gas prices at the pump were hiked by 20% or so, these barely profitable companies will be hit," Charpin says of the auto sector.
Ciaran O'Hagan, government bond strategist at Lehman Brothers, argues high oil prices are not linked to Middle East conflict, but rather to an increase in demand on the back of the economic recovery. "Interest rates are too low. The [European Central Bank] may show its teeth in the next few weeks and raise rates," says O'Hagan. Investors are concerned about inflation and are showing a strong interest in buying protection in the swaps market. O'Hagan is recommending investors sell inflation-linked bonds and buy fixed rate ones. Inflation break-evens are well above the ECB's target 2% at over 2.1% and O'Hagan suggests selling France's OATi of '12 and buying the sovereign's 5% of '12 instead, based on his belief a rate hike is imminent. Euro zone inflation has to be above 2% over the next 10 years on average for OATi investors to break even against the fixed-rate OAT.