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Oil Compression and Yield Flattening: Implied Market Risks Are High

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Oil Compression and Yield Flattening: Implied Market Risks Are High PART 1 OF 1

Oil Compression and Yield Flattening: Implied Market Risks Are High

Perceived risk in the markets is high

Perceived market risk remains elevated. Both the S&P 500 skew and the CSFB Fear Index index remain at or above their ninetieth percentile over the past two years. This highlights continued concerns about what the Fed may or may not do over the next few months as well as two interesting macro issues: the WTI-Brent Spread and the US Treasury market yield curve.

WTI-Brent spread compression ahead of OPEC

The WTI-Brent spread compressed further. It has sat in the ninety-fourth percentile over the past two years (OIL)(USO), meaning WTI has weakened less than Brent. WTI is mainly consumed in the United States, which is drawing on its inventory. The US economy is better, and there’s more demand for oil here than in, say, Europe. Plus, there’s more positive sentiment for oil in the United States. Much of this compression also relates to the USD. Generally, the spread has correlated with the EUR-USD, but over the past year, we saw the USD strengthen against the euro. Meanwhile, for much of the year, we saw WTI actually weaken more than Brent. However, we saw this spread really start to collapse in late summer, when both WTI and Brent meaningfully broke $50.

OPEC meets on Friday, December 4. Most people expect the Saudis not to cut production. However, the options market is pricing in a meaningful move this week. We wouldn’t be surprised to see some unexpected headlines coming out of the meeting. Even a slight cut could send the otherwise beaten-up oil market higher. The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) heavily correlates to oil pricing and could be a good way to get long exposure to the area. We don’t favor holding levered ETFs for long periods—see Realist Ratings Reports on Levered ETFs. Investors looking for a levered quick trade can get 3x long the oil and gas exploration space with GUSH, 2x levered some of the larger oil and gas names with DIG, or 2x levered long WTI with UCO.

Oil Compression and Yield Flattening: Implied Market Risks Are High

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Yield curve flattening?

The two-year-versus-ten-year Treasury spread level is a bit alarming. It makes sense for two-year Treasury yields (SHY) to move higher as the expectations for increases in interest rates rise. At near 0.93%, those yields are now above 2011 highs to levels last seen in 2010. However, longer-dated yields appear to be much stickier than you would expect. The alarming part of this is the idea that we could eventually see an inverted yield curve, which is generally a sign of expected or pending recession. While the ten-year (IEF) is still more than a percent away, the curve flattening does call for concern.

The last time the 2Y-10Y was inverted was in early 2007, albeit at an absolute level of near 5%. There should, however, be inflation risk baked into longer-dated Treasuries. Right now, the ten-year breakeven on inflation is around 1.64%, which is near the lows over the past two years. A flatter curve should make a bank less likely to lend out money, as its spread from where it borrows and lends narrows, which adds another log to the fire of the argument that banks haven’t lent enough during the recovery.

Oil Compression and Yield Flattening: Implied Market Risks Are High

When all is said and done, it’s important to note that the Fed often raises rates to combat USD weakness and curb inflation. The opposite is currently the case. Plus, rate rises are typically the byproduct of strong GDP growth, which also is not the case in the United States. For all these reasons, including the flattening yield curve, we continue to believe the Fed is unlikely to meaningfully raise rates for a very long time. It’s also interesting to point out that the last time the spread flattened below the current levels, it marked the top of the market in 2007.

This research originally appeared in our Market Realist newsletter. You can sign up to get the latest free updates in your inbox.

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