Tuesday, February 24th, 2015

Yields and Crude

The papers this morning were full of speculation about Janet Yellen’s semi-annual testimony to Congress. Tomorrow morning they will be full of interpretation, much of contradictory. We leave it to others to parse the phraseology surrounding patience, but it does give us a good excuse to talk about US Treasuries, and their relationship with oil prices and the US dollar.

Most US investors missed the beginning of the Treasury rally in September, because they kept focussing on US economic data as the driver for yields. We favoured an explanation which highlighted the ultra-low yields in the rest of the developed world, the strength of the dollar and the deflationary impact of the falling oil price. Reading the previews it appears that US investors are still making the same mistake, though recent trends have been in their favour. Both Treasury yields and crude oil prices have rallied for most of February, after very significant falls in each of the previous four months.

We think there is now a danger that this rally may itself be overdone. We note the failure of WTI to break above its 50-day moving average (despite at least two attempts) and the significant increases in US oil inventories. Brent is behaving slightly differently, but if you think – as we do- that the marginal price of oil is now being set in the US and not in Saudi Arabia, you should also believe that Brent will eventually follow WTI and not the other way around. In short we think that the oil-price will retest the lows sometime in the next two months.

One of the factors which would put more pressure on Brent would be if the trade-weighted dollar were to resume its upward march. For most of February it has been below its late January peak, but we saw a similar pause for the month of October which was then followed by a 10% move (high-to-high) over the next four months. We would not be surprised if the TWI started to move higher sometime in March.

Janet Yellen’s speech is part of the story, as is the next FOMC, but events outside the US are also important. Now that the Greek crisis is in abeyance again, the EURUSD exchange rate will be driven by the ECB’s QE programme: €60bn a month starting in March, which will almost certainly push the euro below 1.10. We have also heard little about the prospect of a Chinese devaluation against the US dollar, mainly because the country has been on holiday for Chinese New Year. We expect to hear a lot more about this when their financial markets get back into full swing next week. Our belief is that the authorities there will gradually redefine their FX regime as being a crawling peg based on a basket of three currencies, the dollar, the yen and the euro – the net result being a weaker renminbi.

If we are right and the dollar does start to strengthen again, this makes the yields on US Treasuries attractive to overseas investors again – perhaps not as much as they were in October last year, but certainly difficult to sell in the face of renewed currency appreciation, when even Portuguese 10-year bonds are yielding almost the same as the US now. Long Treasuries, short oil has been a painful position in February. There is a chance that it will be less painful in March.

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