10Y Yields Are Back Above 3% And Oil Is Surging – What Happens Next?

10Y yields rose above 3% again overnight, so I guess Jamie Dimon is getting closer to being “right” all the time.

10Y

I’m just kidding. Jamie Dimon was just spitballing and you people blew his comments out of proportion. But hey, I can’t blame you. “Jamie Dimon Says 10Y Yields Are Headed To 4%” is a good headline when it comes to enticing readers.

The overnight push (back) above the “magic” threshold comes ahead of a $25 billion 10Y auction and amid a further rise in crude. WTI briefly jumped above $71 overnight. Here’s an annotated chart that shows you the whipsaw action from Tuesday, when prices fell on a CNN report, snapped back on a NYT article about Macron and then rose further when Trump spoke:

WTI

To be sure, there are plenty of reasons to believe 10Y yields will remain anchored and that for the time being the dominant mode of the curve will be flattening. We’ve talked a ton about the myriad arguments for why the U.S. long end will continue to find sponsorship. Former trader and current Bloomberg columnist Mark Cudmore is out with something on this on Wednesday. Here’s an excerpt:

Contrary to most hedge funds and analysts out there, I still believe in further flattening of the 2s-10s curve over the medium-term. Treasury 10-year yields at 4% won’t be an issue for markets in 2018. If it is, that implies the U.S. has lost all fiscal credibility and we’ll be in the midst of the next major financial crisis — and it will be worse than last time. But I’m not so bearish — the point I’m making is that there’s no way inflation alone justifies yields getting that high. U.S. 10-year yields have closed above 3% on just one day in the past four years — they never closed above 3.03% in that time.

Duly noted, but in light of recent events, it’s also worth revisiting Deutsche Bank’s contention that rising oil prices could end up being a boon for the dollar in the event they push up inflation expectations. Recall the following excerpts from a couple of late April notes by the bank’s Alan Ruskin:

Oil is working its wonders on inflation expectations. Figure 1 shows 10y breakevens slavishly following oil around. Regressions suggest a $5/b increase in oil is worth at least 10bps on 10y breakevens. Assuming that real yields and breakevens if anything remain positively correlated a WTI near $75/b could precipitate US 10y pushing through 3%.

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If oil helps push the 10y yield into new terrain for this cycle, this will play at least mildly USD positive, in a change of correlation.

The reason why many risky currencies have tended to go up versus the USD when oil goes up is because oil price increases of late have been a favorable demand side story, while in contrast, an Iran inspired oil price increase would be a supply side shock that is negative for risky assets versus the USD. We would expect that oil heading to near $80/b will be associated with a stronger USD against most currencies. This partly relates to the impact at the back-end of the curve, most obviously if the US 10y yield breaks 3.05%. At least as important will be the expected Central Bank policy response. As we have seen in recent days, a few tentative signs of slowing in the global economy will scale back expectations of tightening in most places, while having less impact on the Federal Reserve. The market is taking on board a view that the US will have a large fiscal inspired demand side shock that will more than offset any negative oil supply side shock, unlike much of the rest of the world, and the demand and supply side will provide a double whammy for US inflation pressures

Note that oil vol and FX vol are normally intertwined, in part because oil vol should encourage some uptick in bond vol. Implied oil vol has already picked up a little (see Figure 5), while other markets are lagging. Bond vol is regarded as at the epicenter of any broader increase in vol across all asset classes.

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However, in coming weeks, if oil is a factor pushing US bond yields to new cycle highs, the USD is likely to perform strongly across the board, but most obviously versus the risky non-oil producers.

Again, those excerpts are from a couple of weeks ago, but you can see why I would bring them up.

This seems particularly relevant considering the questions about oil prices following Trump’s decision to pull out of the Iran deal and considering the ongoing inflation debate in the U.S. and the restoration of the dollar’s correlation with 10Y yields.

If the dollar continues to follow yields higher, one has to worry about emerging markets which haven’t exactly demonstrated what one might call “resiliency” over the course of the dollar’s three-week rally.

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