Friday, July 24, 2015

Are lower oil prices really a problem?

The market is still jittery. Stocks are off their recent highs, and it looks to be mainly due to falling oil prices, because they threaten the profits of the oil industry and they also increase the risk of bond defaults. But the positive side to this is lower expected inflation, and for consumers and businesses, lower energy costs. Bad for some, but probably good for most.

The Vix/10-yr ratio has moved up a bit in recent days, and stocks have moved down, as the chart above shows. This inverse correlation is what I call "climbing walls of worry." Stocks fall because the market gets nervous, not because of any fundamental deterioration in the economic outlook. Once the worries pass, stocks move back up.

Lower energy prices increase the risk of default on bonds issued by energy-related businesses. This can be seen in rising credit spreads for high-yield energy bonds in the above chart. The market undoubtedly worries that rising defaults in this sector could spread via "contagion" to other sectors. 

While it's not possible to rule out more widespread defaults, 2-year swap spreads today are trading at very normal levels, both here and in the Eurozone. At these levels, swap spreads are telling us that systemic risk is low and markets have plenty of liquidity. These are very important fundamentals that work to limit the contagion risk of the energy sector.

One reason for the latest bout of market anxiety is falling oil prices, which today have almost returned to their low of last March. Crude oil today is less than half what it was a year ago. As the chart above suggests, the decline in oil prices has been closely matched by a corresponding decline in inflation expectations (blue line). I've calculated those inflation expectations by subtracting the real yield on 5-yr TIPS from the nominal yield on 5-yr Treasuries.

The chart above shows the data used for my calculation of inflation expectations. For the next 5 years, the bond market is expecting the CPI to average about 1.4% a year, which is near the low end of historical experience.

As inflation expectations have declined, the demand for TIPS has also declined; that is reflected in the rising yield on 5-yr TIPS (blue line in the above chart). And it's not surprising that the demand for gold has declined as well (red line). The prices of gold and TIPS (using the inverse of their real yield as a proxy for their price) have in fact moved together quite closely for the past 8 years or so. Inflation expectations and concerns have been in part responsible for this, especially in the past year, but another factor is at play as well: a gradual return of confidence in the outlook for economic growth and stability. I wrote in greater detail about the latter in a recent post, "Descending the Great Wall of Worry."

No one can say for sure whether oil prices will continue to decline. The almost 60% decline in the past 10 months in the number of active drilling rigs in the U.S. suggests that U.S. oil supplies are going to be increasing at a much slower rate going forward. But if the deal with Iran goes through, Iran is going to be slowly ramping up its production over the next year at a time when OPEC is producing at fairly high levels. Meanwhile, it's reasonable to think that oil demand has increased, and in that regard I note that miles driven in the U.S. have increased almost 3% in the past year, whereas they were flat for the previous 10 years. Chinese growth has slowed down, but their oil consumption continues to rise at a relatively fast clip: per capita oil consumption in China rose over 30% in the past 5 years, according to the BP Statistical Review and IMF.

In the meantime, sensitive market-based indicators of systemic risk (e.g., swap spreads) are not showing any signs of concern. This is a good sign that the latest bout of worries is likely to pass.


Joseph Constable said...

The 2 year swap rate may be low but it is on a continuing uptrend since the end of 2013. There is nothing scary about the general high yield spread but it has been in an uptrend since mid 2014. The same goes for corporate spreads, more or less.

Stock market internals really suck. The rotation to so few leaders is ominous. Dividend shares are rolling over. The 30 year has turned up a bit. The CRB commodities index stopped at support yesterday and today handily went below.

The stock market has climbed the wall of worry but has not scaled it.

Benjamin Cole said...

The markets expects 1.4% inflation (on the CPI) for the five years but the Fed wants raise rates?

That indicates the Fed is nearly a full percent below its putative target of 2 percent on the PCE.

That is an abject policy failure.

Bodin said...

Mr. Ben
What would you expect the markets to do if the FEDs back out of raising rates this year?