How America’s Fracking Boom Helps to Boost Treasuries Demand

America’s shale boom is providing an unintended benefit to U.S. government bonds.

With the U.S. economy relying less on oil and gas imports than at any time in two decades, energy expenses for Americans have fallen and cut into inflation more than any other living cost in the past year, according to data compiled by the Labor Department. Economists say consumer prices will rise less than 2 percent for a second straight year in 2014, the first time that’s happened during an expansion in a half-century.

Slowing inflation, which increases the purchasing power of fixed-rate payments, would give support to Treasuries after the Federal Reserve’s plan to curtail its unprecedented bond buying ignited their first annual losses since 2009. Ten-year notes yielded 1.76 percent last month after deducting inflation, close to the highest since 2011. Spending fewer dollars on foreign oil also means that any gain in crude prices no longer leads to a weaker greenback, upending a decade-long relationship that may strengthen the value of U.S. assets.

Rising U.S. oil production means “lower inflation than it would otherwise be, lower interest rates than would otherwise be,” David Kotok, the chairman and chief investment officer of Sarasota, Florida-based Cumberland Advisors Inc., which manages $2.2 billion, said in a Jan. 16 telephone interview. “We don’t have to provide the incentives to recycle the dollar back from a foreign holder, be it friend or enemy” with higher bond yields.

Real Yields

Energy prices have become disinflationary in the U.S. as America comes closer to attaining energy independence, which has been bolstered by the proliferation of hydraulic fracturing, or fracking, of the nation’s shale deposits.

While a Labor Department report last week showed that fuel helped lift consumer prices 0.3 percent in December, the most in six months, energy expenses for all of 2013 still decreased.

The costs of gasoline and fuel oil, which account for about 10 percent of the U.S. consumer price index, fell 0.8 percent last year, the biggest drag on annual inflation of 1.48 percent. Oil prices will fall 5.5 percent in 2014, according to an annual forecast from the Energy Department, which will help limit the increase in living expenses to 1.7 percent this year.

The last time the cost of living in the U.S. rose less than 2 percent for two straight years during an expansion was in 1964 and 1965, Labor Department data show.

Smaller consumer-price gains are helping boost the appeal of Treasuries as inflation-adjusted yields rise, according to Jack McIntyre, a money manager at Brandywine Global Investment Management LLC, which oversees $45 billion.

‘Treasury Exposure’

Real yields on the benchmark 10-year note climbed to within 0.1 percentage point of highest level in 34 months on Dec. 27, according to data compiled by Bloomberg. The greater the real yield, the more debt investors are insulated from a loss of purchasing power as the dollars needed to buy the same amount of goods and services increase.

The 10-year note yielded 1.32 percentage points more than the rate of inflation today, higher than the average of 1.07 percentage points in the past decade, data compiled by Bloomberg show. As recently as March, real yields were negative.

“That’s why we have Treasury exposure,” McIntyre said in a telephone interview from Philadelphia.

Treasuries, which posted just their fourth annual decline since 1978 as an improving U.S. economy strengthened the Fed’s case to taper its stimulus, are now off to the best start in five years. The $8.3 trillion of U.S. government debt from 1-year notes to 30-year bonds included in the Bank of America Merrill Lynch U.S. Treasury Index has returned 0.8 percent in January after losing 3.4 percent last year.

Energy Independence

Yields on the 10-year note were little changed at 2.82 percent as of 12:28 p.m. in New York after falling for a third week to 2.82 percent in the five days through Jan. 17. The price of the 2.75 percent bond due in November 2023 was 99 11/32.

Demand for fracking, a method used to fracture underground oil- and gas-bearing rock formations such as the Bakken shale in North Dakota and the Eagle Ford in Texas by injecting a mixture of water, sand and chemicals to create cracks and release the fuel, increased as rising oil prices in the past decade made it more affordable to explore on land than under water.

The U.S. is producing so much oil from fracking that the Energy Department estimates output will surge this year to the highest since 1986, helping to cap energy costs domestically.

Government restrictions on crude exports also mean increasing production helps insulate the world’s largest oil-consuming nation from price shocks stemming from fluctuations in foreign supplies.

‘More Reliable’

West Texas Intermediate crude, the U.S. benchmark grade, will decline to $93 per barrel this year from $98.42 at the end of 2013, based on the Energy Department projection. As recently as July, analysts in a Bloomberg survey estimated that the price of oil would increase to $103 by the end of 2014.

Crude oil futures have already fallen 4.5 percent this year, with WTI futures ending at $94.37 per barrel last week. That’s $12.11 less than a barrel of Brent crude, the European benchmark grade. The WTI discount is currently three times as wide as the average of $4.02 over the past decade.

“The more that we produce, the more reliable our source is, and that’s certainly going to help keep a lid on prices,” James Sarni, senior managing partner at Payden & Rygel, which manages $85 billion, said by telephone from Los Angeles. “Inflation will be lower for longer than people think and whatever rate rise we do see will be less than people think.”

Structural Inflation

Yields on 10-year Treasuries will climb to 3.45 percent by the end of 2014, according to the median forecast of 69 economists in a Bloomberg survey.

A stronger U.S. economy will spur consumer demand that lifts prices more consistently as wages increase, which may offset declines in energy costs and erode the appeal of Treasuries, according to Ira Jersey, a New York-based interest-rate strategist at Credit Suisse Group AG.

“Wage inflation tends to be more structural and tends to last longer,” Jersey of Credit Suisse, one of 21 primary dealers that are obliged to bid at U.S. government debt auctions, said in a Jan. 14 telephone interview.

The world’s largest economy will expand 2.8 percent this year and accelerate 3 percent in 2015, which would be the fastest in a decade, based on economists surveyed by Bloomberg.

The Fed, which has flooded the economy with more than $3 trillion to stimulate growth, will cut monthly purchases of Treasuries and mortgage-backed securities to $75 billion from $85 billion this month.

OPEC Dollars

The bank will then reduce buying by $10 billion in each of the next six meetings before ending its stimulus in December, according to 42 economists surveyed by Bloomberg in January.

Higher U.S. oil output is also leaving the Organization of Petroleum Exporting Countries with fewer dollars to invest in Treasuries. OPEC nations are on track to hold fewer Treasuries at the end of 2013 than the start, which would be the first annual decline since 2003. OPEC members held $236.2 billion of Treasuries at the end of November, 9.8 percent less than at the end of 2012, government data show.

Nevertheless, spending fewer dollars abroad to buy crude oil means the U.S. currency is no longer depreciating as demand for crude rises, which may ultimately help preserve the value of Treasuries for foreign creditors. They hold almost half of the nation’s $11.8 trillion in marketable debt obligations as of November, with China and Japan together owning $2.5 trillion.

Over the past decade, the dollar has usually weakened whenever crude rose. That relationship broke down last month, according to data compiled by Bloomberg.

Feedback Loop

The 120-day correlation between the two assets, which has averaged minus 0.3 over the past 10 years, turned positive in December before climbing to 0.033, which was the highest since February 2003, data show.

A reading of minus 1 means two securities always move in opposite directions, 0 means their moves aren’t related at all and 1 indicates that they always move in the same direction.

In July 2008, when oil reached a record $145.29 a barrel, the dollar traded at $1.57 per euro, within three cents of its record low. The same month, U.S. consumer prices also rose by the most in 17 years, surging 5.6 percent from a year earlier.

“There can certainly be a very positive circular feedback loop,” said Alan Ruskin, the New York-based global head of Group of 10 foreign-exchange at Deutsche Bank AG, the world’s largest currency trader, in a Jan. 16 telephone interview.

This year, the dollar is forecast to appreciate to $1.28 per euro from a current $1.3530 and to 110 yen from 104.72, according to Bloomberg surveys.

History Lesson

America has pursued energy self-sufficiency ever since Arab producers declared an oil embargo in the autumn of 1973 to retaliate against the U.S. government for assisting Israel during the Yom Kippur War. The energy crisis caused chronic fuel shortages in the U.S. that ignited inflation and pushed the economy into a recession, becoming a precursor to a phenomenon known as stagflation which emerged later in the decade.

America’s borrowing costs soared as investors demanded more compensation to hold U.S. government debt, with yields on 10-year Treasuries eclipsing 8 percent in 1974. An inflation rate of 12.34 percent that year meant that holders of Treasuries were left with a loss of about 5.3 percent in real terms, according to data compiled by Barclays Plc.

Now, the U.S. is on the verge of surpassing Russia and Saudi Arabia as the world’s largest producer of oil, according to the International Energy Agency.

“You deserve a stronger currency, stronger financial markets, a better role within the global financial system because you are not dependent” on imported oil, Brandywine’s McIntyre said.

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