Treasuries & Oil Reverse Traditional Relationship
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Treasuries & Oil Reverse Traditional Relationship

The recent run-up in the price of oil and the Treasury market's counter-intuitive rally marks a full reversal of the traditional relationship between energy prices and bond yields.

The recent run-up in the price of oil and the Treasury market's counter-intuitive rally marks a full reversal of the traditional relationship between energy prices and bond yields. Fixed-income watchers expect the reversal to be a temporary phenomenon that offers an opportunity for trading accounts to benefit from a return to the norm. Traditionally, energy prices and Treasuries have been inversely correlated because rising energy costs were seen as inflationary. But the latest spike in oil prices has been accompanied by a decline in Treasury yields on expectations that higher prices will slow the Federal Reserve's interest-rate hikes. The benchmark 10-year yielded 4.26% on Aug. 25, down about 20 basis points for the month of August even as the price of oil flirted with a more than 20-year high of $50 a barrel. Last week, oil began to come off its highs and moved to the mid-$40s.

The bond market's hope is that the Fed sees higher oil prices as potentially harmful to an economic recovery and therefore may not raise rates as quickly as it would otherwise.

"[High oil prices have] in the past slowed down economic growth," said Dave Boberski, head of interest-rate strategy at Bear Stearns. That being said, he downplayed the prospect of a sustainable oil-fired Treasury rally and questioned whether the high price will really dissuade the Fed from further near-term rate hikes. "This is a total red herring. [The Fed] has to look very far down the pipeline and some transitory peak in energy prices isn't going to steer their thinking," he concluded.

Other observers agreed the reversal of the traditional relationship between Treasuries and oil may just be temporary. Mike Alftsad, president of RW Smith Fixed Income, an advisory firm located in suburban Seattle, said the bond market has been discounting high energy prices because of an assumption that the economy is not strong enough to pass along these costs. He added new sources of demand are putting increased strains on the oil price and the overall effect it will have on consumer prices. "The market is under-appreciating [the demand from] China and the strains it is putting on commodities. Even if [oil] stabilizes around $40 a barrel, it is an inflationary event," he added.

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