The Tell: Don’t blame oil prices for a widening gap in government bond yields, says BMO


Hysteria over a flattening yield curve saw a brief reprieve after a sharp selloff in long-dated government bonds sent the 10-year Treasury yield in striking distance of 3%, a key psychological level.

See: Stock investors are freaking out about bonds ending a 3 decadelong bull run—but should they be?

As a result, the spread between the 2-year yield

TMUBMUSD02Y, -0.15%

and the 10-year yield

TMUBMUSD10Y, -0.38%

 has snapped back to 51.4 basis points, still relatively flat, but a large move given that the gap stood at a prerecession width of 41 basis points only on Tuesday.

However, fixed-income gurus Ian Lyngen and Aaron Kohli of BMO Capital Markets say there are plenty of reasons to doubt “the almost universally accepted narrative…that higher commodity prices and the potential for tariffs to trigger pockets of inflation have caused the selloff.”

Market participants had blamed the swiftness of the bearish move on the oil prices

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nearing $70 a barrel which drove 10-year break-even rates, or inflation expectations, over the next decade, close to a more than three-year high of 2.19%, according to Tradeweb data. The corrosive power of higher prices on asset values tend to be felt more acutely at the back-end of the bond market.

Past data, however, showed that higher crude prices were related to a flattening of the yield curve, not a steepening one, said Lyngen and Kohli. The yield curve is a line drawing out a bond’s maturities against rates, with a steeper curve indicating a wider gap between long-dated rates and short-dated rates.

In the chart below, the spread between the 5-year note yield

TMUBMUSD05Y, -0.24%

and the 30-year note yield

TMUBMUSD30Y, -0.29%

one popular gauge on which traders bet on the shape of the curve, has been negatively correlated with oil prices. In other words, the more expensive oil became, the flatter the yield curve.

BMO Capital Markets

The yield curve is related to the flattening

That relationship could reflect the Federal Reserve’s tendency to act more aggressively to tamp down temporary inflation pressures stimulated by higher energy prices. The BMO strategists said if core inflation, stripping out for energy and food prices, pushed above 2%, a steepening yield curve was warranted, but they didn’t sense an upshift in inflation.

Though, the central bank has publicly stated it ignores the ups and downs of crude values, “the notion that near-term [inflation] breakevens are rising means the FOMC has an enhanced ability to push more nominal hikes into the front-end without materially affecting the real rate in a corresponding manner,” said Lyngen and Kohli.

That is, the central bank might have the headroom to raise the fed-funds rate further as higher short-term inflation offsets the rise in borrowing costs, keeping the rise in real yields, or inflation-adjusted rates, contained. Climbing oil prices could thus provide a welcome opportunity for a Fed that wants to push up interest rates to build up ammunition for the next recession but not to the point monetary policy starts to materially hurt economic growth.

Some-market participants have argued a breakout in the real yield and not in the nominal yield is ultimately more destabilizing for financial markets as it leads to a more acute tightening of credit conditions.

The close ties between a flattening curve and higher commodity prices could also suggest that the economy is overheated and entering the last innings of its economic cycle.

“We expect some upward pressure on crude also partly as a result of the fact that we’ve seen recessions preceded by energy spikes, and see it as part of a late-cycle phenomenon that signals the end of the expansion as the Fed accelerates hikes,” Lyngen and Kohli said.

The strategist duo added that higher oil prices could soon reach a threshold where it starts to weigh on a global economy saddled with a record amount of debt.

Their pessimism is shared by other investors. Seventy percent of investors polled in the B.of A. Merrill Lynch fund manager survey for February suggesting the U.S. economy was in the latter stages of its uptrend, a stage marked by elevated commodity prices, tighter credit, higher inflation, and a more aggressive pace of monetary tightening.

Jeffrey Gundlach at DoubleLine Capital, speaking at the Sohn Investment Conference, said commodity indexes tended to outperform the S&P 500 index

SPX, +0.01%

 entering recessions.

Read: Is U.S. economy prepared for oil prices at $70 a barrel?

Also check out: Global debt has reached a record high, IMF says, and three countries are to blame

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