Seeking Alpha

Oil Prices And The Economy In 2019

by: John M. Mason
John M. Mason
Banks, long-term horizon

The decline in oil prices since early October seems to be having a major impact on bond markets with the implication that the US economy could be under threat.

Specifically, the financial markets are reflecting a substantial decline in inflationary expectations, which tied to other parts of the bond market indicated that oil price concerns are real.

The Treasury market has benefited from the concerns and bond prices have risen, but the reverse has happened in corporate bond markets and junk bond markets.

Many readers could tell, I am sure, of the surprise I expressed in discussing, on Friday, the recent decline in yields on US Treasury securities.

Most of this year I, along with others, had been expecting Treasury yields to increase. We believed that with the yield on the 10-year Treasury note breaking through the 3.00 percent barrier, that interest rates would just keep going higher.

The yield on the 10-year security rose to around 3.25 percent.

But, recently, longer-term Treasury yields have been declining. On Friday, the 10-year yield closed at 3.03 percent.

This wasn’t supposed to happen. The Federal Reserve is supposed to raise its policy rate of interest at its December meeting of the Federal Open Market Committee (FOMC) meeting. The Fed is also reducing the size of its securities portfolio. The budget of the federal government seems to be increasing out of control. The United States economy seems to be proceeding fairly well. The European Central Bank is expected to end its time of quantitative easing this year, producing the expectation that European interest rates will be rising next year.

And yet, here was the yield on the 10-year Treasury dropping from its peak on November 8 to the low reached on Friday.

In my last post, I dissected the yield on the 10-year Treasury security into its two components, the expected real rate of interest and the expected rate of inflation.

What I found was rather surprising. The decline in the nominal yield on the 10-year Treasury security was almost solely coming from a decline in inflationary expectations.

The basic question I asked was, “how could this be?”

With the economy growing at a pretty good rate, unemployment at a 49-year low, the government debt was expected to grow at a very rapid rate and the Fed’s projection for future inflation indicated that the inflation rate was expected to remain fairly close to the Fed’s 2.00 percent goal… or even, some concluded, slightly above this level.

Why should the financial markets be saying that for the next 10 years, the compound rate of inflation was expected to be around 1.90 percent… or even lower?

Two possible factors were suggested. First, some analysts were saying that there was going to be a slowdown in world economic growth, specifically in Europe and China. The economists at the International Monetary Fund were one source for this forecast.

The second factor was the oil market and the decline in oil prices coming over the past two and one half months or so. The price of oil has declined over this period by more than 30 percent since reaching a four-year high in early October.

In discussing the decline, analysts have talked about the current “oversupply” of oil, but they have not forgotten the possibility that the world economy could slow down.

Nicole Bullock and Greg Meyer ask in the Financial Times, “How much of the swoon is down to a sudden oversupply in the market and how much is down to fears of a broader economic slowdown coming next year?”

And, Ms. Bullock and Mr. Meyer provide references to people taking either side of this issue.

Of course, we are going to have to wait a little bit to see what does happen. OPEC is having meetings this week and discussions are also going on in Russia and elsewhere about the current supply.

As far as the slowdown in the economy, well, that is a little further out, time wise. A signal to look for… the price of Brent crude oil. On Friday, the price of Brent crude “dropped back below $59 a barrel.”

But, Ms. Bullock and Mr. Meyer quote Michael Arone, chief investment strategist at State Street Global Advisors: “If Brent were to fall to around the $45 mark that becomes a much clearer signal that it is not just an oversupply challenge, but really is slowing global growth. Then it becomes more problematic for a broader swath of the market.”

But, there are other signs in the financial markets. Stephen Grocer writes in the New York Times that “Investors are growing nervous about corporate debt. Falling oil prices deserve some of the blame.”

“The average yield on risky company bonds has climbed to 7.3 percent.”

“Notably, junk bond yields have moved higher as the rate on Treasuries has retreated.”

Why? American energy companies have been the biggest issuers of high-yield bonds since 2015, according to Dealogic, and their bonds account for about 15 percent of the market. "As the price of crude falls, investors’ concerns about the health of these companies and their ability to pay off the bonds, grows.”

But, this in not all. We read in the Financial Times that “Credit Markets Set for Worst Year Since 2008 as Investors Shed Corporate Debt.” Because of this, the authors of the article, Adam Samson and Robin Wigglesworth, write, “concerns mount over the outlook for 2019.”

During 2018, the authors report, there has been a “derisking” of bond funds.

Something is going on in the bond market and this all seems to be connected with concerns flowing from the fall in oil prices. And, as Christopher Allessi writes Saturday in the Wall Street Journal, “Banks in November lowered their forecasts for oil prices in 2019 amid signs of rising global supply and a price rout…”

Obviously, something is going on here that we need to keep abreast of. There are a lot of places, a lot of markets, where a “break” could come, causing the financial markets and economies to spiral into a collapse. The difficulty always is to identify, among all these places, where the actual “snap” is going to occur.

It looks to me like we need to keep a closer watch across all bond markets. The buildup over the past two months of concerns about the oil markets, the financing of energy companies, and possibility that economies throughout the world might be facing more “headwinds” than earlier imagined seems to be greater than maybe we had imagined. And, the thing is, these concerns are coming out in not just one market… but, in several.

We certainly need to keep an eye on what is going on here.

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.