May 10, 2005
KEEPING THE FAITH
For the last three decades of the 20th century, oil and bond yields shared a stable, if hostile relationship. When the price of crude went up, so too did government bond yields. When oil prices fell, Treasury yields declined as well.
This has been no accidental relationship, writes economist David Wheelock, assistant vice president at the Federal Reserve Bank of St. Louis, in a new piece that asks the timely question: "Has the bond market forgotten Oil?"
In 2005, at least, the answer seems to be a reluctant "yes." Crude, based on the nearby futures contract traded in New York, has climbed 20% this year through today's closing price of $52.07. The yield on the benchmark 10-year Treasury Note is essentially unchanged over that span. Over the longer haul, the disparity between the two is even more dramatic. During the three years through last month, oil's climbed more than 80%, while the yield on the 10-year has fallen by around 87 basis points.
It's hard to argue that the bond market's obsessed with oil these days, yet once upon a time the fixed-income set was impressed, if not obsessed with the vicissitudes of crude. The reason was inflation, Wheelock explains. "In the 1970s, a rising price of oil often presaged a sustained increase in the rate of inflation; bond investors responded by demanding higher nominal yields to protect their real returns. Similarly, in the 1980s and 1990s, when oil prices and inflation generally fell, bond yields also fell."
No more. In the 21st century, the bond market gets worked up over precious little, least of all rising oil prices. It's fair to say that the former rapport between oil and bonds has been torn asunder. Wheelock advances several theories for the breakdown in the linkage. One is that the recent rise in oil's price coincided with the U.S. economy climbing out of the doldrums that prevailed in 2001 and 2002. During the revival of economic momentum, inflation was low and the rebound in the labor force was below par. "Few analysts viewed inflation as a threat and, as employment continued to lag, a few warned that deflation was possible," Wheelock writes. "In this environment, government security yields remained low."
Ah, but how does a thinking investor square that plausible analysis of the past with the here and now? Indeed, inflation is starting to bubble higher again, albeit on a low level thus far. Meanwhile, oil prices show no signs of retreating much below $50 a barrel. Is the yield/oil relation of yore doomed to make an untimely return?
Indeed, the labor market continues to gain momentum on the upside, as last week's surprisingly strong jobs report for April reminds, and the Fed has been signaling its determination to tighten the monetary strings for the foreseeable future. The year 2005 is shaping up to be a lot less friendly regarding the fostering of conditions that presumably led to the breakdown in the yield/oil association of a few years earlier
No matter, as the bond market seems in no particular rush to do much of anything at the moment. Despite a roller coaster of economic news in recent weeks, the 10-year's yield hasn't changed much in the last month. In fact, in today's trading session, the 10-year's yield fell, signaling that the bulls of fixed income aren't about to go away quietly.
Then again, maybe the explanation for the new relationship between oil and yields lies elsewhere. Wheelock also ponders the notion that the low bond yields have prevailed because the country sports a greater energy efficiency compared with years past. What's more, some think that the price of crude will soon fall sharply.
Wheelock also opines that the market's trust in the Federal Reserve's commitment to successfully beating inflation into submission is a factor. "The importance of maintaining a stable price level is much more widely recognized today than in the 1970s, and the bond market has considerable faith that the Fed will not allow inflation to rise (or fall) significantly from its present level," he explains. "As long as such faith persists, the price of oil can rise and fall without causing large movements in bond yields."
Spoken like a true member of the central banking establishment. And who can argue? Although the pace of inflation, measured by the year-over-year change in the monthly consumer price index, has risen in recent years, it's no higher than it was a decade ago. Advancing at 3.1% in March, CPI is increasing at a rate that prevailed during the first half of the 1990s.
But faith, like hot restaurants and the latest rate of change in inflation, can be a slippery fish. All the more so when it comes to central banking, which may be under different management in the very near future in light of the approaching forced retirement of Alan Greenspan on January 31, 2006 from the board of the Federal Open Market Committee.
In the meantime, faith springs eternal in the bond market. Looking through a rear-view mirror gives one confidence that the optimism is well founded. But does the analysis hold up when looking through the windshield at the road ahead?
Posted by jp at May 10, 2005 5:23 PM
Fascinating post (and comment)
Posted by: rjw at May 14, 2005 11:58 AM
or if/when yield curve inverts
Posted by: Jonathan at May 11, 2005 4:04 AM
IMHO, the yield curve is on its way to being completely flat. Forget everything we've learned about how the yield curve is supposed to move.
In the new world: The Fed anchors the short end and Asian Central Banks anchor the long end. Massively leveraged hedge funds flatten the curve through carry trades.
As the Fed continues to tighten, expect the long end of the curve to remain flat in comparison.
Why is this so. Imagine you're a hedge fund manager. Of all the strategies at your disposal, the easiest to understand and manage is the carry-trade. You don't have to run it naked either. You can eliminate a bunch of the risk with deerivate contracts.
Here is the perverse part: the yield curve will get flatter faster. Last year, with a solid 300 basis point difference, carry traders could make gobs of money with some leverage. This year, with the difference having been reduced to less than 150 basis points, you have to leverage up even more to maintain your profits. So, as the yield curve has gotten flatter, carry traders have had to leverage further, making the curve flatter.
Where does this end? When will the yield curve revert back to its old ways? The answer -- never. As long as a bid is present on the long end -- thanks to China/Japan/et. al -- hedge funds can play the short end off the long.
This isn't risky macro-economics here. This is arbitrage. The only thing that will stop this for Asian Central Banks to revert to reality. That is unlikely to happen for a long, long time.
Posted by: Mr.SantaMonica at May 10, 2005 10:18 PM