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?