Sat, Jan 28, 2023 @ 15:55 GMT
HomeAction InsightSpecial TopicsHow is US Yield's Breach of 3% Related to Recent Crude Oil...

How is US Yield’s Breach of 3% Related to Recent Crude Oil Rally?

The two most astonishing features in the financial market over the past week were soaring US Treasury yields and crude oil prices. After making a fresh 4-year high last Friday, the 10-year yield extended gains and eventually broke above 3% this week. Meanwhile, both crude oil benchmarks rallied to new highs in more than 3 years last week. These are consistent with increasing US inflation expectations and heightening speculations of further Fed funds rate hike. The abovementioned phenomena are by no means coincidence. Rather, they are interrelated.

The first chart below shows that movements of oil price and 10-year US yield have been closely linked. The second chart suggests that the correlation between the two has fluctuated significantly over decades. However, the correlation has been positive, and increasingly so, since last year.

Demand/supply is the key driving force of oil price. While the recent strength in oil price has been driven by tighter supply as a result of OPEC/ non-OPEC commitment to reduce output and geopolitical tensions mainly in Syria and concerns over US possible sanctions against Iran, the demand side of the equation has indeed improved. The Paris-based International Energy Agency (IEA) revised higher its global demand growth forecast to 1.5M bpd for this year, up +0.2M bpd from the previous month’s projection. The agency attributed the revision to strong demand from China and India, which taken together take up almost half of the world’s demand growth. Meanwhile, both US Energy Department (EIA) and OPEC have also upgraded their demand growth forecasts.

As a critical factor of production in various sectors and industries, higher oil demand is an indication of stronger economic activities, hence reflection of the macroeconomic health. At the same time, energy, as a key component of inflation, takes up over 7% of the weight in US headline CPI. Rising oil price inevitably lifts inflation.

Treasury yields of longer maturities typically reflect investors’ expectations of future short-term interest rates. There are indeed the market expectations of future Fed funds rates, of which the outlook is determined by inflation and employment. With US unemployment rate steadied at record low level of 4.1% for six months in a row, the focus is on inflation. Here is where oil price and Treasury yields converge. Upbeat US data have sustained yields at elevated levels. Recent rally in oil prices have heightened inflation expectations which in turn intensified speculations for future Fed funds rate hikes. Such speculations have evidenced in the bump in 10-year yields.

Featured Analysis

Learn Forex Trading