Are Oil Prices too Low?

Back in late April I wrote a post called 'Dot-to-Dot-to…Not?', which joined the dots from mortgage rates to oil prices…and how their price evolution had been counterintuitive to the move in equity markets: the risk aversion exhibited by fixed income markets and caution shown by oil prices did not jive with the emphatic rally seen in equities. Just a few months later it seems worth revisiting the subject, as there has been some dramatic moves since and some key takeaways to, um, takeaway.

This was the first chart from April's post, showing how closely the 30-year mortgage rate tracks the 10-year Treasury yield.

Three and a half months on, and the two remain in lockstep, as you would expect. However, both yields and mortgage rates bottomed out around the time of the last post, and have spiraled higher since on the impending expected tapering of stimulus measures. The tapering of bond purchases means an end to artificially low interest rates, and accordingly, borrowing costs have increased:

The second chart from the original article highlighted the divergence in the first quarter of this year between equities and bond yields, signalling that one of them was off-kilter. After all, conventional wisdom states that as equities rise on positive news, bonds should fall (ergo, bond yields rise).

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And since April we have seen conventional wisdom return. Bond yields have played catch-up to the equity market, charging higher ahead of impending tapering and with renewed hope for an improving economy. Meanwhile, equities have pushed on to further record highs, spurred on by economic optimism:

Finally, where all paths lead back to: energy. Back in April, there was a divergence between oil and equities, as oil was side-stepping the risk-on rally, while equities charged on:

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Fast forward to August, and this divergence remains. Oil has traded broadly sideways in the past three months, while equities have continued higher on their merry way:

So what does this mean? Oil is now the odd one out. In contrast to April, when equities were the outlier of the three assets, oil finds itself ostracized as bond yields join equities in rallying.

This raises the question as to whether the oil price is too low, and equities / bond yields are too high. Or perhaps it just highlights another possibility: has oil detached from broader markets this year to be much more focused on its own fundamentals?

Whereas in April this possibility was mottled by sympathetic movements in the fixed income market, now in August it would appear this scenario to be more likely the case. Just as gasoline demand in recent years has edged lower while the job market has recovered, perhaps a divergent oil market is the new norm, especially with US oil production at a 24-year high.

Or perhaps, as the twinges at the back of our minds indicate, we are just long overdue a correction in equities. Time will tell.

By. Matt Smith