Black Gold
In “Black Gold,” Soul Asylum foreshadowed today’s reality when the Minneapolis band sang “Two boys on a playground, tryin’ to push each other down, see the crowd gather ‘round.” As the spat between President Trump and Iranian leader Khamenei continues and the world watches, our market seems beholden to another kind of black gold.
Crude oil has never been more popular according to Google, with the word garnering the highest browser inquiries in the United States and worldwide earlier this year (Figure 1). Separately, “Hormuz” also hit its most popular search query after being seemingly dormant since Google Trends’ inception. Yet it is the price of oil that has become the operative factor regarding the future path of inflation and, potentially, monetary policy in the near term.
Approximately 20% to 25% of the global supply of oil passes through the Strait of Hormuz (as does about 20% of global liquefied natural gas), while another 10% to 12% of the world’s oil goes through its southwest counterpart at the Bab el-Mandeb Strait. Both chokepoints are critical in Middle Eastern oil transportation routes, and the recent open/shut dynamics have increased price volatility dramatically. As explained in previous Talking Points, the downstream effects on the price of goods and services from energy are key in determining inflationary pressures and subsequent monetary policy. While the June inflation report noted minimal disruption to the core figure, market dynamics have been spared less.
In recent weeks, for example, the U.S. Treasury market seems to have risen/fallen in sympathy with oil prices; the rolling correlation between oil and the 10-year Treasury note yield generally strengthened when the Middle East conflict worsened, due to concerns about inflation and supply shocks. In this instance, oil prices and bond yields tended to move higher together (Figure 2). The correlation weakened, however, when negotiations, ceasefires, or progress toward reopening the Strait of Hormuz reduced those risks and allowed oil prices to decouple from rates and trade on economic fundamentals. Overall, the pattern closely tracks the market’s changing assessment of geopolitical risk and its potential impact on inflation and growth.
Furthermore, the correlation between the changes in the price of oil and changes in daily interest rates began increasing at the onset of the Iran war (Figure 3). The peaks and troughs in these charts should be taken as a culmination of market behavior—not a point-in-time headline reaction—because they’re calculated on a rolling basis. In other words, the chart below encapsulates market sentiment related to the buildup in hostilities or retreatment toward normality.
Tandem correlation is not a new phenomenon, though. There is historical precedent for oil and rates moving in the same direction during hostile times. For example, in September 1990, roughly one month after Iraq’s invasion of Kuwait and three months after a stock market record high, the rolling correlation between oil and the yield on the 10-year note reached +0.92, signaling a very strong positive relationship. The catalyst was Operation Desert Storm. The market concern at the time was focused on the war-related loss of Iraqi and Kuwaiti oil, which could have caused an inflation spike and, with it, restrictive monetary policy.
During testimony before the Joint Economic Committee in September 1990, Alan Greenspan, then Chairman of the Federal Reserve, described the risk: “Despite the general sluggishness in business activity this year, the underlying trend in inflation has not improved. In fact, the core rate of inflation in consumer prices may have crept higher … Moreover, the chance of a significant break soon in the inflation trend would seem to have diminished in view of the additional pressures from oil prices.” The Fed, in short, was concerned about inflationary pressures, which were in the 4% to 6% range. And the market’s hope to avoid a surge in inflation was dwindling due to rising energy prices (Figure 4).
Similarly, the correlation tumbled in the summer of 1991 (to -0.95) when the war was over, thereby allowing the two markets to dissociate from one another. The decoupling occurred quickly: After the war ended, oil normalized and the economy entered a recession, thus shifting the Fed’s focus to accommodation and lower rates.
Meanwhile, the 2003 Iraq war is a great counterexample in terms of correlation, but the market dynamics during that period were very different. In 2002 to 2003, the Consumer Price Index was in the 1% to 3% range, job growth was still negative following the 2001 recession, and the stock market was 47% off the previous high. In the Iraq war, markets focused on economic uncertainty and safety, instead of inflation and rate hikes.
Today’s markets, in contrast, are focused on inflationary fears and supply disruption. Only several months ago at the March meeting of the Federal Open Market Committee, Jerome Powell, while still Fed Chairman, said: “Near-term measures of inflation expectations have risen in recent weeks, likely reflecting the substantial rise in oil prices caused by the supply disruptions in the Middle East.”
“Higher energy prices will push up overall inflation,” added Powell. “[But it is] too soon to know the scope and duration of the potential effects on the economy.” Similarly, in April, Fed Governor Christopher Waller said, “While central bankers rightly tend to discount the effects of temporary oil supply shocks, it was apparent that a prolonged disruption in that [Middle East] region could have a lasting effect on inflation and U.S. economic growth.” Waller returned to the topic in a speech a month later: “Because of the growing length of the conflict, I have become more concerned that higher energy prices may have a lasting effect on inflation.”
A potential reason for the increased focus now on inflationary pressures is the AI/data-center buildout and the related hit to electric and natural gas prices in most of the U.S. Fed researchers also recently published an article on the economic effects of AI: “AI-related components have contributed meaningfully to quarterly GDP growth, with software and computer and peripheral equipment the largest positive contributors.” For its part, software investment, data-center construction, power infrastructure and computer equipment spending have all increased, but productivity has yet to meaningfully show up in the economic data.
On the other hand, demand for electricity and natural gas have surged, creating an inflationary impulse. As BMO strategist Ian Lyngen put it: “For now, the AI boom has been deemed a current source of inflationary pressure that provides incremental justification for the hawkish skew to the near-term monetary policy outlook.”
Mark Twain supposedly said that history doesn’t repeat but often rhymes. The Gulf War was preceded by stock market exuberance, followed by combat, fears of rising inflation, and weakening labor markets—which were eventually followed by normalization, recession, and lower rates. And both the Gulf War and Iraq War show how the correlation between oil and interest rates builds up, or breaks down, based on economic conditions at the time and the prevailing thoughts of the Fed.
Still, the Gulf War likely provides the best comparison to current times—the fears of war ended up not pricing into the inflationary picture, while pricing pressures fell and rates declined. In our mortgage world (and beyond), we should hope for a quick end to the Iran war and, with it, a similar decline in rates.
Until then, Soul Asylum may have said it best. “Moving backwards through time … That side’s yours, this side’s mine … Won’t you fill up the [now expensive] tank? Let’s go for a ride.”
FROM THE DESK
Agency CMBS — No major changes, week over week. There was little supply, given the rate selloff; only around $500 million of new issue Fannie Mae DUS came to market. DUS spreads were flattish. Ginnie Mae TBA supply was also constrained—although it seemed that some borrowers who were waiting for the war to end and for rates to drop finally capitulated and locked rates. Ginnie Mae spreads were two to three basis points tighter, week over week.
Municipals — AAA tax-exempt yields moved materially higher across the curve for a second consecutive week, amid elevated new issue supply and softer market sentiment. Primary issuance surpassed $10 billion last week, and investors continued to absorb new deals, albeit at higher yields and wider spreads. Despite recent weakness, municipal market fundamentals remain constructive: August reinvestment flows should provide a meaningful technical tailwind in the weeks ahead. Municipal bond mutual funds recorded $174 million in inflows during the week, including $91 million into high-yield funds. This development reflected continued demand for tax-exempt income, despite a notable slowdown from the robust inflows of the past six weeks.
The information contained herein, including any expression of opinion, has been obtained from, or is based upon, resources believed to be reliable, but is not guaranteed as to accuracy or completeness. This is not intended to be an offer to buy or sell or a solicitation of an offer to buy or sell securities, if any referred to herein. Lument Securities, LLC may from time to time have a position in one or more of any securities mentioned herein. Lument Securities, LLC or one of its affiliates may from time to time perform investment banking or other business for any company mentioned.
