The interest rates market is recovering lost ground from last wk’s smoking carnage on the back of a monster move in the oil market over the weekend. It’s important to understand why this matters for rates, especially given current conditions in the bond market.
1. OIL SHOCKS ARE NOT CREATED EQUAL
Over the last 30+ years, what’s become quite obvious to the macro community is that price shocks for oil aren’t created equal. That is to say, we’ve transitioned rapidly from regimes where negative supply shocks come in the context of an overall risk-off tone to markets versus similar magnitude shocks that are actually seen as a beneficial outcome for macroeconomic conditions (c.f OPEC production cuts after crude’s tumble in early 2016).
We can see this in the following plot which shows all the 2+ z-score positive 1-day price shocks for oil over the past 30+ years versus the subsequent 5-day z-score move for 10y yields. It’s should be clear from this plot that there are 3 primary regimes.
The “mild” negative supply shock tends to generate a 1-day increase of 1.5-2.5 z-scores in oil & is accompanied by a decrease in yields. These moves tend to be contextualized by a slight risk-off environment typically related to Middle East tensions, but don’t end up being major outliers.
The “moderate” negative supply which is represented by a 1-day increase of 2.5-3.5 z-scores in oil actually generates a small impulse higher in yields. This is due to the fact that, at that magnitude, the inflationary element of the increase takes hold – impacting everything from gasoline prices to input margins at the corporate level. Despite the fact core CPI is intended to control for these increases, it’s difficult to entirely eliminate their effect on overall price behavior.
The “major” negative supply shock is one where the 1-day increase of 3.5+ z-scores in oil generates a meaningful risk-off condition which completely swamps the potential for positive inflation feedback. The negative supply shock might indeed trigger a compensatory response (i.e. SPR release) that provides a buffer against higher prices but does little to mitigate the risk-off effect. If we close around these levels, that’s what it looks like today’s move amounts to.
What’s important about that is the 5-day expected move in interest rates for such a shock: roughly 1.5 z-scores lower in yield, using a 90-day rolling history. That’s particularly important because of the degree of volatility we’ve seen lately in the rates market. 3 months ago, a 1.5 z-score (90d history) move in yields might be 5-6bps. Today it’s 10bps+. That’s because we’ve gotten such an explosion of realized volatility in the interest rates market over the past month.
Further dynamics of this move in rates are discussed here:
In other words, even if today’s move in oil ends right here – we should still expect the subsequent 5-day reaction in rates to be quite large.
2. THIS ISN’T AN INFLATION STORY (YET)
Today’s move for inflation breakevens has been fairly muted. The ~2bps increase for 5-year breakevens barely registers amongst the positive moves this year for inflation products.
It’s been entirely forgotten further out the inflation curve, as you might expect from a one-off price shock.
This should be expected. A large enough negative supply shock that’s sufficient to demand a compensatory response from the DOE, for example, is unlikely to be productive in generating multi-year inflation. That offset could also be found in one-off releases from the SPR, for example:
In any event, a true inflation scare from a negative supply shock would require a much more substantive change in overall production schedules (c.f 1970s). At least at this point in the game, that doesn’t appear likely.
That being said, we do tend to see a bias towards steeper curves in the bond market following large negative supply shocks for oil, as you can see below in the plot of 1-day moves in oil vs subsequent 5-day moves in the 5s10s rates curve.
However, this result comes less because of the inflation dynamic and more as a general bull steepening due to the reaction for monetary policy – which will be addressed in the final point.
3. REACHING THE FED’S RADAR
As should be obvious by this point, the Fed is fond of such verbiage as “transitory” when it comes to the description of price shocks in the energy market (something we have seen going back decades in the discussion topics that make their way into the minutes).
Discussion of “energy markets” in general barely make their way into the official recaps of the FOMC meetings.
It’s important to note that this contrasts with an overall obsession the Fed seems to have with broader financial markets – a dynamic I explain here:
It’s done nothing today to impact the expectations for Wednesday’s FOMC (the market assumes -25bps is a foregone conclusion at this point).
But what it has done is increase the odds of cuts later this year.
Essentially, we’re back to pricing in at least one more cut in December of this year after Wednesday’s presumptive 2nd cut of 2019. That’s a meaningful difference from where we went out the door on Friday.
An intensification of geopolitical concerns on the back of this move in energy markets would likely shift this distribution further again to the left – where it’s been for a large part of the last month – as the Fed weighs further action that might, possibly, be required in order to keep the current expansion going… That’s the most important element necessary to consider as markets contemplate the next move after an extraordinary weekend.
References, Sources : Bloomberg, HFR Research, SocGen Hedge Fund Monitor, CME Group.
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