Will the “Inverted Yield Curve” impact the price of crude oil?
On 14th Aug 2019, the 10 -year US Treasury bond yield fell below the yield on two-year bonds, creating an Inverted Yield curve. This scenario occurred for the first time since the financial market crisis of 2007-08. Now, before we get to whether this economic phenomenon will impact crude prices, let’s first back up a little and understand what an inverted yield curve is and how it impacts economies, in general.
What is an inverted yield curve?
Generally speaking, an inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. It signals the future perception of businesses to be uncertain and usually is an omen of a looming recession.
Inverted US yield curves and recessions
An inverted yield curve for US Treasury bonds is among the most consistent recession indicators. A look at the most recent previous inverted yield curve, which manifested in 2006, reveals that it was a precursor to the 2008 financial crisis. It occurred two years before the meltdown.
In fact, there have been “Inverted Yield Curve” formations before US recessions since 1950.
Source: FRED, Ventura Securities Ltd
Currently, investors and economists are especially worried, mainly due to the fact that there is no end in sight to the US-China trade war and some sectors, particularly automobiles, are facing a downturn.
So, is a recession imminent?
In the past, the inversions of the yield curve typically occurred when rates were rising. This time, however, rates are generally following a downward trend. The exception occurred in 1998, wherein a falling rate scenario culminated in an inverted yield curve. Even during that instance, the curve re-steepened, and there was no recession over the following two years.
Secondly, while inverted yield curves may be precursors to a recession, not every inversion has been followed by a recession. In the past, a recession did not follow three of ten inverted yield curve situations.
Currently, only the ‘Yield Curve’ in the US has touched the bottom, other indicators such as the ISM and the Housing market trend are in the ‘Neutral’ space and other leading indicators are in ‘Positive’ territory.
Nevertheless, despite past occurrences in 1980, 1990, 2001 and 2008, it does not seem likely that 2019-2020 will witness a recession.
1. Firstly, due to rate cuts in the US and stimulus programs across the globe, there is hope that a lower interest rate regime could offset the ill-effects of a recession or pre-empt it all together. Stimulus packages could arrest the slowdown and restore economic growth.
2. Secondly, we could see a resolution to the US-China trade war, ahead of the US Presidential Election in Nov 2020.
As a result, we expect that either there will be an outright exception to the rule and the current inverted yield curve will not be an indicator of a recession or there could be a prolonged delay between the current yield curve inversion and a recession. Of course, one other major factor of uncertainty which could topple the equation is how the BREXIT will pan out.
What does this signal for crude oil?
Very clearly, it suggests an up-move in the price of crude oil.
The United States and China are the two top consumers of crude oil, followed by Japan and India.
Any slowdown in these countries would put pressure on crude demand and drag down prices. However, a recovery in the US will trigger a pick up the demand for crude, which in turn will lead to higher crude prices.
There are signals of recoveries in the US economy
- U.S. Manufacturing PMI and China PMI have witnessed an uptick (See graph at the end of the article).
- Negotiations between the US and China are seeing some positive moves.
- Central Bank stimulus measures (in the form of rate cuts) have been initiated in various countries, including and quite importantly, the US, China and India.
Technical outlook for crude
The WTI Nymex Crude is trading @ USD 55 per barrel. Technically, the trend line is holding strong support at USD 50 levels. We expect the price to head towards USD 58-60 in the short term (i.e. around 2 months).
Short term View: USD 60 (1 to 2-month period)
Medium Term View: USD 65-68 (3 to 5-month period)
Long term View: USD72-76 (8 to 9-month period)
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.