Oil Markets Ignore Warning Signs Of Looming Recession

When you write about financial markets as I do, being a profit of doom can be a good short-term strategy, and that short-term nature makes it an effective one in the modern ADHD world. A headline about an impending “collapse” or “crash” is, after all, much sexier than “We will probably go a bit higher over time because that is what has happened consistently over the last two hundred years or so…”, and a sexy headline draws clicks and eyeballs. Fear sells, but there are two reasons to avoid exploiting that.

First and foremost, it is irresponsible. The vast majority of investors are best served by riding out the market’s gyrations and, no matter how clear you might try to make it that your views are aimed at traders rather than long-term investors, some people will read a doom and gloom piece, sell everything and miss out on good gains. Second, if you do it all the time, it becomes counter-productive. You can only be wrong so many times before you become the boy crying wolf.

So, I hesitate before using the “R” word. “Recession” has a specific definition in economics, it means three months of negative GDP growth, but for most people it is just a term for really tough economic times. With the events of 2008/9 a decade away but still within memory, that is a scary thing. Still, the two markets that decades of dealing room experience taught me are the most reliable indicators of brewing trouble are flashing clear warning signs of recession.

The yield curve for U.S. Treasuries is, this morning, now fully inverted from 1-Month out to 10-Years. Interest rates for longer term loans or bonds tend to be higher in normal circumstances. Investors demand higher returns when tying up money for a longer period, so when, as is now the case, the annualized return on 10 Year paper is less than 1-Month bills, it is significant.

The Fed announced this week that there would be no rate hike this month, but also indicated that the pace of “normalization” would be slowing just about to a stop for a while. That could be seen as a good thing in a “mission accomplished” kind of way, were it not for one thing. In October last year, 5 months and just one 25-basis point rate hike ago, Fed Chair Jerome Powell said that we were " …a long way from neutral interest rates". Something must have changed, right?

Well, yes. What has changed is the Fed’s view of the economy, both domestic and worldwide. In the statement and press conference that accompanied this month’s “no decision” they joined the IMF, the World Bank, and the OECD in issuing a gloomy outlook for global growth and made their view clear that if and when that starts to show, it will affect the U.S.

Nor is it just the world’s leading economists who see trouble ahead. Several markets are indicating the same thing. In addition to U.S. Treasuries, Bunds, the German government bonds, are also trading at very low, in many cases negative, yields. There are obviously a significant number of investors who think it worthwhile to pay a small penalty to get return of capital, rather than look for a return on capital. If that isn’t enough, the dollar, seen as a safe haven buy, bounced straight back from its post-Fed announcement drop and remains at elevated levels, and gold, another fear indicator, is recovering strongly after a summer swoon last year.

Yet, with all these warning signs clearly visible, two major markets are, for different reasons still relatively robust, U.S. stocks and oil. The stock market’s excuse is that it is focused on U.S. performance, not just intrinsically, but in relation to elsewhere. With the U.S. economy looking like it will slow less than others, or at the very least will start to do so later, the domestic, short-term focus of stock traders enables them to stay bullish.

The oil market’s reasons for ignoring the warning signs are a bit more understandable. The focus in the oil market for some time has been supply. The agreed output cuts from OPEC members and a few others cut supply initially, then as prices rose, U.S. shale production increased dramatically. Now, with that growth slowing and sanctions against Iran and Venezuela really beginning to be felt, the oil market is tightening again. That is something that is actually happening, whereas a global demand slowdown is something that might happen. In that context, buoyancy in crude makes sense.

Even so, the longer other markets keep their warning signals flashing, the harder it will be for stocks and oil to ignore them. Global growth may not be the topic du jour in either of those markets, but ultimately, it matters, and unless things change, both can be expected to correct.