Late last month, prompted by what was, at the time, the latest edition of JPMorgan’s “Flows & Liquidity” series, we revisited the petrodollar flows story in light of the recent surge in crude prices.
Prices have of course risen to their highest levels since 2014 on the back of supply jitters catalyzed by the Trump administration’s decision to pull the U.S. out of the Iran deal and Venezuela’s ongoing efforts to cement its status as a failed state.
Last week, WTI managed to log a third straight week of gains while Brent has risen for six consecutive weeks. Bottom line:
This is taking place despite the dollar rally and indeed, it’s adding fuel to the fire for the greenback as real rates in the U.S. have become to a certain extent a function of inflation expectations. As the latter rise, the market assumes the Fed will be more predisposed to tightening and that underpins the dollar, which has seen its correlation with 10Y yields and rate differentials restored of late. Here’s the key chart:
But there’s another avenue by which crude is contributing to the rise in yields and it was tipped in the JPMorgan note mentioned above.
Essentially, the bank argues that while the re-accumulation of reserve assets by oil exporters could theoretically act as a counterbalance to the wind down of DM QE, the other side of the coin is a hit to consumers, whose capacity to save falls as oil prices rise.
In effect, this is a reversal of the dynamics that were at play in 2015, when plunging crude prices raised concerns about “QT” in the form of EM reserve manager de-accumulation. Those fears were exacerbated starting in late August 2015 when China began liquidating their reserves in an effort to control the pace of the yuan devaluation (i.e., in an effort to keep expectations of further weakness from manifesting themselves in a depreciation that went well beyond the mid-August deval., which was pitched as a “one-off”).
A cursory take on rising crude prices would be that oil exporters will rebuild reserves, potentially providing a bid for USTs, but as JPMorgan argues in a followup to the above-mentioned note, the loss of savings from oil consumers tied to rising crude prices actually outweighs the reserve reaccumulation technical, leading to a net negative effect on bonds. To wit, from the bank’s Nikolaos Panigirtzoglou:
The massive boost to income for oil consumers between 2014 and 2016 had created a supportive savings flow into fixed income. In particular we believe that a decent part of the previous $1.8tr income windfall seen between 2014 and 2016, equally split between the residential sector, the industrial sector and the transportation sector, was likely saved. These savings most likely took the form of bank deposits which eventually supported bond markets via the banking system deploying these excess deposits into government bond markets. As a result, the oil income windfall to households and oil consuming industries had likely created a bullish flow into fixed income between 2014 and 2016, bigger in size than the bearish fixed income flows resulting from the decumulation of SWF/FX reserves of oil exporting countries during these two years. The opposite has been happening since 2016.
The bolded bit there is key (that’s why I bolded it). Again, the argument is that the windfall savings to consumers from 2014 to 2016 offset the loss of revenue to oil exporters in terms of the read-through for the global fixed income market. If that’s true, then it stands to reason that the opposite is happening now. Here’s another excerpt:
These positive bond flow dynamics emanating from oil consumers started reversing post 2016 as oil prices started rising and as the previous income windfall started eroding. Again, factoring in a rise in oil price from $45 in 2016 to $55 in 2017 and $80 in 2018 implies an income squeeze of $1.1tr for oil consumers, a decent portion of which likely taking the form of reduced flow of savings. In turn, this exerts downward pressure on overall bond demand, and upward pressure on bond yields.
If that’s the case, well then there’s a double whammy going on here (at least for U.S. yields), where inflation expectations slavishly follow crude higher and the net bearish investment flow outlined by JPM leaves a dearth of demand for bonds.
For their part, the bank says that the oil flows effect is the controlling factor for yields (not breakevens). On that score, we’ll leave you with one last passage from the note:
While the temptation is to associate [the relationship between yields and oil prices] with inflation expectations, we believe that this is not credible explanation. Most of the recent rise in bond yields has been due to real yields rising rather than inflation breakevens. Instead we believe that bond markets reacting to an anticipated flow shift caused by the rise in oil prices is a more credible explanation.