Is Crude Oil Correlated To The 10-Year U.S. Treasury Note?

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Jonathan Prather

Summary

Is there a relationship between the 10-Year and crude oil?

How correlated (or inversely correlated) are the two indexes?

What implications could a correlation have on the bond market?

Introduction

To determine if crude is correlated to the ten year U.S. Treasury note, we have to scale back first and examine the correlation between crude oil and interest rates (interest rates are inversely correlated to bond prices). Through my research, I have determined that the crude index and interest rates do have some correlation. The fact is though; there are countless variables that impact interest rates and oil prices both independently and conjunctively.

Theory

One basic theory is that when interest rates rise, consumer and manufacturers cost rise which, in turn, reduces the amount of time and money consumers spend on transportation. The decrease in transportation results in a decrease in consumption which in turn causes oil prices to drop. In this case, interest rates and crude would be inversely correlated. Theoretically then, when interest rates drop, consumers and firms are free to borrow and in turn spend money more freely. Increase consumption drives up demand for oil, and eventually price adjusts to match demand.

Another theory is that high interest rates strengthen the dollar relatively to other countries' currencies. A strong dollar helps American oil companies buy and import more oil at cheaper prices. Ultimately, the oil companies pass on the savings to consumers. Likewise, when the value of the dollar is low, it becomes costlier for American oil companies to import. Thus, a decrease in supply causes oil prices to increase in the U.S. market. Also, a weaker U.S. dollar may increase export demand which may be beneficial to the overall U.S. economy (particularly manufacturing) which would increase domestic demand for oil from the industrials sector.

With that being said, there are factors that affect crude and interest rates independently. Overall economic outlook may give the Federal Reserve the incentive to raise rates or lower rates. For example, when the U.S. faced stagflation (when economic growth is slow and inflation is high) in the 1970s, Volcker raised interest rates to historic highs in order to combat runaway inflation. Factors such as wars, lowered/raised OPEC output, hurricanes, and investor sentiment towards crude are largely uncorrelated to interest rates.

Testing the Theory

To prove that crude oil is correlated to the 10 year note I must:

  • Prove that interest rates and bond prices are inversely correlated

  • Explain the relationship between the 10 Year U.S. Treasury note and interest rates

  • Show that interest rates and crude oil are semi-correlated

  • Explain correlation between the 10 Year U.S. Treasury note and crude oil.

Inverse Relationship Between Interest Rates and Bond Prices

Interest rates and bond prices are inversely correlated. To see why, think about the zero coupon bond. If a zero-coupon bond is trading at $1,900 and has a par value of $2,000, then the bonds present rate of return is equivalent to (($2,000-$1,900)/$1,900) = 5.26%. The trader is happy with that current yield, but the trader's happiness is also tied to the market as a whole. Like any investor the bond holder wants the best return possible. If interest rates rise and newly issued bonds yield 10%, then the zero-coupon bond worth 5.26% will have no demand at all. The only way to match demand would be to decrease the value of the bond to match current yields at 10%. So the bond holder would have to sell at a new price of 1,818. On the other side of the equation, if interest rates decrease and bond's yield pushed down to 2%, then the original bond at 5.26% will look attractive and the price of the bond will increase. For this reason, the bond holder benefits when interest rates decrease. Here is a simple chart to understand the relationship between interest rates and bond price.

Annual Interest Rate

Semi-annual interest rate

Bond Price

7.0%

3.5%

$95.48

6.9%

3.45%

$95.70

6.8%

3.4%

$95.92

6.7%

3.35%

$96.15

6.6%

3.30%

$96.37

Recap of Bond Prices and Interest Rates

An interest rate hike will cause different results in the bond market. First, the price of the actual bond will decrease relative to the increase in interest rates to reflect its market value. Conversely, a decrease in interest rates will equate to higher bond prices Current bond holders will benefit from the price increase, and they could sell their bond at a higher price than what they paid before the bond reaches maturity.

The Ten-year Treasury note

The ten year note is essentially a loan made to the U.S. government. It is sold at auction and it matures in a decade. It is one of the most popular debt instruments in the world, and it is backed by the guarantee of the U.S. economy. The ten-year Treasury note rate is the yield, or rate of return the investor receives. The bond is sold at a fixed face value and interest rate. The yield is the term used to describe the total amount of money you make on the U.S. Treasury note. Yields are determined by supply and demand. When demand is high the bond will go to the highest bidder at a price above the face value. This lowers the yield, because the government will only pay back the face value plus the stated interest rate. When demand is low the bidders will pay less than the face value which will increase the yield, which is why yields move in the opposite direction of bond prices. Yield prices change every day because they are bought and sold daily on the open market. On a macro-level, the Ten-year Treasury note yield is quite possibly the most important benchmark for determining interest rates. Interest rates could also mean anything from the Federal funds rate, the 30-year fixed interest mortgage rate, or any of the other Treasury note yields. The aforementioned indexes tend to move in conjunction with each other. Additionally, the Ten-year is often used as the risk free rate in equity valuation. In summation, when treasury yields increase, so do interest rates on similar length business and consumer loans. The safe and fixed returns of treasury notes are attractive to investors, and as yields raise so do interest rates on other bonds and loans to remain competitive. Overtime, higher yields increase demand for treasuries, and the cycle continues.

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Testing the Correlation of U.S. 10 Year Treasury yields and Crude Oil

Now that I've shown the synonymous relationship between ten-year yields and interest rates I will test how U.S. 10 Year Treasury yields correlate to crude oil . To accomplish this I compiled all the data from the Federal Reserve Bank of St. Louis available through eia.gov onto an excel sheet. The data set I compiled is daily prices of WTI and constant maturity yields of the 10 year Treasury note. I listed dates going back to 1986 for both indexes all the way until present day. After that, that I ran a correlation function to determine how well they compared to each other.

Graph showing WTI to 10-Year correlation

Results

Ultimately I determined that daily crude oil prices and 10-year constant maturity yields are inversely correlated at -0.7592. Based on the evidence I found, my hypothesis seems to hold true. While -.7592 is not perfectly inverse, it does show a strong correlation between the too. It is certainly significant. I could have used a shorter time frame to determine how effective this correlation would be relative to current prices; however, I wanted to focus on the long term correlation between the two to get a long term vision for the two indexes.

Conclusion

Based on the evidence I found, there is a long-term inverse correlation between daily oil prices and constant maturity yields for the 10-year Treasury. There are more factors to test such as short term correlation and percentage change. There are countless implications. I would like to focus primarily on the bond market however. For long-term bond holders it is important to remember that interest rates and prices are inversely correlated. Since yields and oil prices are inversely correlated as well, it can be shown that theoretically a long term investor could profit by hedging crude against 10-year yields. In the short run this may not apply, but in the long run it might. Additionally, bond prices may be semi correlated to crude prices.

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.