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It’s The Oil, Stupid



Rising crude prices have grabbed headlines of late and it’s important to understand how oil factors into what some analysts are calling “cyclical melt-up 2.0”.

There’s a connection here to the vaunted “convergence” trade.

It’s tempting to ascribe the relationship between crude and bonds to inflation expectations.

But one bank thinks that’s not a “credible” explanation.

Here are the details.

Late last month, I wrote something for you folks called “The Bond Selloff That Nobody Noticed“, which was a kind of sweeping effort to document the possible causes behind a Treasury (TLT) selloff that appeared to be gathering momentum.

That post was written after a week that saw the “convergence trade” finally take hold in earnest. During the week of September 17, emerging market equities logged a stellar performance. In fact, the iShares MSCI Emerging Markets ETF (EEM) had its best week relative to the SPDR S&P 500 Trust ETF (SPY) of the year. MSCI’s gauge of EM FX had its best week since February. For their part, mainland shares in China (the focal point of EM equity malaise) had their best week since May of 2016 as the Shanghai Composite outperformed the S&P by the most for any week in more than two years.

That all unfolded against a backdrop of dollar (UUP) weakness, underscoring how important it truly is for the greenback rally to take a breather if ex-U.S. assets are going to get back on track. That week’s dollar weakness played out even as Treasury yields rose. That perplexed some observers, and seemed to mark a return to the dynamics that persisted in late 2017/early 2018 when the greenback stubbornly refused to respond to rising U.S. yields and a concurrent favorable shift in rate differentials. In January and February, that stubbornness was variously attributed to market participants being concerned about the deteriorating fiscal outlook in the U.S. and also to the notion that the administration’s trade stance is a weak dollar policy by proxy.

In the post linked here at the outset, I speculated a bit about the Treasury selloff and the dollar and why the latter didn’t respond to the former. Here’s the key excerpt:

It’s possible that higher yields abroad and renewed expectations of developed market monetary policy convergence are sapping demand for the long end of the U.S. Treasury curve. It’s also possible that this week, the risk-on move catalyzed in part by dollar weakness reduced the appeal of safe haven Treasurys. Also note that the causation works both ways there. Reduced demand for USD assets (i.e., Treasurys) is USD negative. A weaker dollar begets more risk-on sentiment, in a loop. Additionally, the dollar is negatively correlated to global growth, so stimulus rumors out of China and the reflation hope those rumors engendered, likely played negative for the greenback as well. Finally, it’s possible that folks are starting to refocus on the U.S. fiscal path and on the prospect of the Trump administration talking down the dollar in an effort to avoid a scenario where the stronger greenback waters down the tariffs on China.

Since then, the global reflation narrative has gathered a bit more steam, despite mixed economic data. Consider this from Nomura’s Charlie McElligott, out Monday (more here):

The pieces are in place for the tactical October ‘Cyclical Melt-up 2.0’ [with] USTs and USD on their back-foot post Canada / NAFTA 2.0, while Commodities and EMFX rally to multi-week highs [and] Brent moves towards its 100-month MA. This ‘up-in-risk’ trade comes despite disappointing Asian & Euro-Area Manu PMIs as well as a weaker Japanese Tankan print.

This plays into the idea that rising crude prices (USO) could end up being what breaks the “unprecedented” divergence between U.S. stocks and the rest of the world. To be clear, rising crude prices aren’t positive for all EMs, but to the extent the rally in oil helps push commodity prices higher across the board and thereby lends credence to the global reflation narrative, it could help reignite risk sentiment outside the U.S. That’s what the above-mentioned McElligott means when he talks about a “cyclical melt-up”.

Have a look at the following chart which is the ratio between the S&P and the MSCI All Country World (ACWI) plotted with the Bloomberg commodities index:


Do recall that the dollar weakness and Treasury selloff mentioned above (i.e., price action during the week of September 17) came in conjunction with comments out of Riyadh which indicated Saudi Arabia is now comfortable with $80 crude. The concurrent rally in commodities reinforced dollar weakness and pushed breakevens higher (i.e., fed into the divergence between the greenback and Treasury yields):


Ok, so two takeaways from that narrative (and these are inextricably bound up with one another): 1) A weaker dollar, surging crude and concurrently higher commodities prices are helping to reinvigorate the global reflation narrative which is in turn helping to bolster risk sentiment in previously downtrodden EM assets, 2) Rising crude prices are likely to push inflation expectations higher and that’s weighing on bonds.

One person who isn’t entirely convinced of point number two is JPMorgan’s Nikolaos Panigirtzoglou, who pens the bank’s popular weekly “Flows And Liquidity”. In the latest edition, Panigirtzoglou rehashes an argument he’s been making for quite a while. Namely that it’s a mistake to attribute the relationship between 10-year Treasury yields and oil prices to inflation expectations.

I’ve documented Panigirtzoglou’s thoughts on this before (most recently back in April), but it’s worth highlighting some excerpts from his latest given that, as outlined above, the oil-commodities-reflation story is starting to get some traction again, this time in the context of the all-important “convergence” trade.

First of all, it’s not hard to understand why market participants are inclined to say that the relationship between crude and bond yields is down to inflation expectations. Here’s a simple chart of Brent and 10-year Treasury yields:


And here’s Brent with breakevens:


But Panigirtzoglou thinks the interpretation is at best tenuous and at worst, wrong. “While the temptation is to associate this relationship with inflation expectations, we believe that this is not credible explanation”, he writes, in the Friday note mentioned above.

If you follow Panigirtzoglou’s work on this, you know that he attributes the relationship between crude and Treasury yields to the ebb and flow of recycled oil windfalls.

Back in April, when he last broached this subject, Panigirtzoglou noted that oil exporters raked in some $1.6 trillion from crude in 2014, a figure that dropped precipitously to < $800 billion in 2016. Here’s how that translated into “QT”:

In 2014, around 84% or $1.4tr of the $1.6tr oil revenue was recycled via imports and the remaining 16% or $260bn was recycled via SWFs and FX reserves, mostly SWFs. In 2016, 118% or $930bn of the $800bn of oil exporters’ revenues was recycled via imports of goods and services from the rest of the world, $140bn of which was funded by SWF and FX reserve decumulation.

If you do the math there, that means that in the space of just two years, there was a ~$400 billion decline in reserve accumulation from oil exporters. That’s “QT” – depending of course on what they’re “decumulating”.

Of course, there are two sides of this. What was lost to oil exporters was gained by consumers and on JPMorgan’s estimates, “the oil income windfall to oil consuming industries had likely created a bullish flow into fixed income during 2015 and 2016, bigger in size than the fixed income flows resulting from the decumulation of SWF/FX reserves of oil exporting countries during these two years.”

That quote is from the April analysis in which the bank went on to say that the reversal of the savings impulse from lower oil prices among consumers will actually mean that the flow for bonds from higher oil prices is a net negative this year – that is, the hit to consumers from rising oil prices and the assumed reduction in their capacity to save via fixed income will outweigh the reverse of petrodollar recycling into DM bonds by oil exporters.

In his latest note, Panigirtzoglou updates the math on this using JPMorgan’s new forecasts for oil prices. To wit:

Oil consumers spent $3.4tr on crude and related products in 2014 with an average oil price of $100 per barrel, and in 2016, they spent less than half of that, i.e. $1.6tr with an average oil price of $45 per barrel. In other words, there was a massive $1.8tr or 2.2% of global GDP income transfer between oil consumers and oil producers between 2014 and 2016. These income transfers have been reversing over the past two years as the average oil price has risen from $45 during 2016 to $55 during 2017 and to a new YTD high of $82 currently. If we assume an average oil price of $85 for the remainder of 2018 and $84 for 2019, in line with our oil analysts’ forecasts, it would mean that 70% of the previous 2014/2016 income transfer would have been reversed between 2016 and 2019, with more than half of this reversal taking place between 2017 and 2018.

This take is a bit counterintuitive in the context of recycled oil windfalls, which means it’s easy for folks to get turned around. Let me just reiterate: Panigirtzoglou is essentially arguing that whatever bullish impulse for bonds might materialize from oil exporters recycling petrodollars in an environment of higher crude prices will be outweighed by the bearish bond impulse from oil consumers whose capacity to invest is hindered by paying more for the world’s most financialized commodity. Here’s Panigirtzoglou driving the point home:

The massive boost to income for oil consumers between 2014 and 2016 created a supportive savings flow into fixed income. In particular, we believe that a decent part of the previous $1.8tr income windfall seen between 2014 and 2016, equally split among the residential sector, the industrial sector and the transportation sector, was likely saved. These savings most likely took the form of bank deposits, which eventually supported bond markets via the banking system deploying these excess deposits into government bond markets. As a result, the oil income windfall to households and oil-consuming industries, as well as the accumulation of FX reserves of oil-importing countries likely created a bullish flow into fixed income between 2014 and 2016, bigger in size than the bearish fixed-income flows resulting from the decumulation of SWF/FX reserves of oil-exporting countries during these two years. The opposite has been happening since 2016. These positive bond flow dynamics emanating from oil consumers started reversing post 2016 as oil prices started rising and as the previous income windfall started eroding.

This adds yet another dimension to the debate around where long end, developed market bond yields are headed. This discussion is already clouded by a number of factors, including ambiguity about the pension fund bid for Treasurys following the expiration of favorable tax treatment, questions about when (and if) the term premium will finally be rebuilt as investors demand more compensation to hold longer dated U.S. debt against a deteriorating fiscal backdrop, the possibility that hedging costs will further sap foreign demand and, of course, the possibility that a series of above-consensus inflation prints (e.g., AHE or CPI) in the U.S. end up adding fuel to the bond selloff.

Meanwhile, that record spec short in the 10-year got even more stretched in the week through last Tuesday and depending your inclination to view that as a contrarian indicator, one might argue that any acute risk-off episode could squeeze that position, leading to a sharp drop in yields.


In any event, to the extent you’re inclined to buy into (figuratively or literally) the idea that the global reflation story is back and that higher crude prices and a rebound in commodities more generally will catalyze a risk asset-positive rise in Treasury yields (remember: rising inflation expectations and higher yields can be a boon for risk sentiment depending on how the market perceives the “why”, as it were), Panigirtzoglou’s thesis serves as something of a counterpoint.

For the bond traders out there, JPMorgan’s take on this should be seen in the context of the myriad factors at play in the long end, as described above.

As far as equities are concerned, I’ll leave you with one last quote from Panigirtzoglou:

What about the impact of higher oil prices on equity markets? The rise in oil prices should in principle create a positive flow into equity markets this year via increased SWF accumulation and increased share buybacks by oil companies. But this additional equity flow is likely to be negligible this year.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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One Comment on "It’s The Oil, Stupid"

  1. Dredd on Wed, 3rd Oct 2018 9:11 am 

    “It’s The Oil, Stupid”

    No, “It;s The Stupid Oil

    Also (On Thermal Expansion & Thermal Contraction – 37)

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