Most Likely You Go Your Way (And I’ll Go Mine)
Oil’s sawtooth pattern last week was attributable to the on-again, off-again talks between Tehran and the White House. The market has been struggling to determine if conversations are still happening behind closed doors, while public rhetoric on each side remains heated. These negotiations will hopefully play out similarly to the in-fighting among our own members of Congress, where radio and television appearances signal unreconcilable disdain, just before a late agreement and the averting of disaster.
Bob Dylan seemed to have had a bead on current events when he sang: “I just can’t beg you anymore, I’m gonna let you pass, and then time will tell just who has fell, and who’s been left behind, when you go your way and I go mine.” Dylan, like the markets, seems to think that the Strait of Hormuz will reopen and ships will be allowed to pass, but is unsure on the victor of the war just yet. Either way, it remains doubtful that Iran and America will become friendly in the near term, but perhaps a ceasefire is in the offing. For now, however, each side is going their own way—although President Trump extended the timeline to find an accord before resuming attacks on Iran’s public works. Oil prices, nevertheless, remain elevated through this uncertainty, with West Texas crude reaching $101/barrel by Friday’s close, well above the prewar cost of $57, but off the recent intraday high of $118 of March 8 (Figure 1). Meanwhile, Brent crude, Europe’s benchmark, closed near $115/barrel on Friday, versus $61 pre-war.
We’ve discussed the likelihood of rising energy prices permeating inflationary pressures through downstream channels, like fertilizer costs, chemicals, food, and transportation. This week’s Talking Points focus instead on market-based measures with respect to interest rates and historical cycles of rising oil prices.
Figure 2 shows changes in the yield on the 10-year Treasury note through periods of sustained increases in oil prices, dating to the 1980s. The charts show that in nearly all cases, interest rates rise in sympathy with bouts of upward crude costs. The beginning and middle stages, however, are a bit murky—the average and median changes show a cross-current, but the final stages are more definitive. These variations are likely due to the lagged nature with which prices work through the economy and, ultimately, affect monetary policy.
The opposite is also true: Periods of falling oil prices were associated with declining interest rates in all but one case (Figure 3). Yet those declines tended to be gradual and spread out over time.
In short, the recent runup in crude oil prices is hardly benign. Indeed, using quarterly changes in price, we have now breached a two standard deviation event. These occurrences are rare, but not unprecedented. The most recent example was after the start of the Russia/Ukraine war in early 2022. Then, oil prices peaked in May 2022, when Russia’s invasion of Ukraine stoked supply concerns along with heavy sanctions. Following that peak, fears of a global recession—fueled by aggressive central bank hike cycles, slowing demand (in the U.S. and abroad), and rising crude stockpiles (a sign of both lower demand and inventory builds)—brought oil prices down, even though rates increased due to the Federal Reserve’s intense rate hikes.
The second most recent two standard deviation event followed the Covid-19 pandemic, when travel restrictions finally lifted and unleashed pent-up demand, combined with limited supply and production capacity. Treasuries sold off sharply alongside this meteoric rise in prices, which subsequently kicked off the Fed rate-hike cycle.
Earlier, following the Great Financial Crisis, global demand picked up and central banks were broadly accommodative. From a federal funds rate perspective, the Fed was on hold (with its zero interest rate policy). The recovery increased global demand and caused oil prices to rise steadily—and with it, longer duration interest rates rose in sympathy for the following 12-month period. Similarly, in late 2017–18, oil prices rose primarily due to production cuts by OPEC+ members, strong global demand, and rising geopolitical tensions. This period coincided with a fairly mild rate-hike cycle from the Fed.
The takeaway: The supply and demand metrics that govern energy prices are tangentially intertwined with the broader economic narrative. In most cases, demand for oil is a similar demand for productivity; with that comes inflationary pressures and higher rates. The current landscape is somewhat similar to the GFC example—oil prices have shocked higher, but amid a Federal Reserve that was on a lower rate path.
Since the recent peak in oil prices after the start of the Russia/Ukraine war, the U.S. economy has been in a more downshift mode, marked by slowing inflation, job growth, and non-stellar output. As such, it wouldn’t be far-fetched to expect a return to the status quo, barring this latest exogenous shock (the war with Iran). This shock, admittedly, carries an unknown duration/timeline. If solved in the near term, probabilities would lean toward a resumption of trend, which was slower inflation. But if the war drags on, then inflationary pressures could really take hold, leaving central bankers in a quandary.
FROM THE DESK
Agency CMBS — Investor sentiment was cautious, given the amount of market volatility last week and waning confidence that such volatility (and the Iran war) will end soon. Fannie Mae spreads reflected that sentiment by increasing 3–6 basis points, week over week. Dealer balance sheets remain full, which ought to has helped keep a lid on spreads in that space. Ginnie spreads were flat to 1 bp wider, week over week.
Municipals — AAA tax-exempt yields again moved higher across the curve, week over week. Expect more volatility in the muni market until the conflict in the Middle East appears closer to ending. Municipal bond funds saw outflows for the first time in 17 weeks. Investors pulled $600 million from funds last week, bringing year-to-date inflows to $16.04 billion. Bond outflows this past week can be attributed to market volatility and the tax man.
Looking for more economic insights? Check out all of our previous Trading Desk Talk posts.
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.
