Bond Traders to Yellen: You’re Wrong on Oil’s Impact on Economy

Janet Yellen has dismissed plunging oil values as a fleeting shock to the economy. Bond traders disagree.

The latest slump in oil has investors dumping their junk-rated energy securities and slashing their predictions for inflation. Energy-related high-yield bonds have tumbled 3.4 percent this month and dollar-denominated notes that are hedged against accelerating prices have declined 2.1 percent.

Federal Reserve Chair Yellen affirmed her view on Wednesday that the impact from lower oil prices on inflation will be transitory. But bond traders aren’t waiting around to find out if she’s right. The 10 percent plunge in crude prices this month has them repricing the economic outlook years out and paring investments that are most vulnerable to further losses.

“Credit markets have been very keenly focused on oil prices,” said George Bory, a credit strategist at Wells Fargo & Co., in a Bloomberg Television interview Tuesday. The ballooning amount of energy-related debt has led investors “to use the credit markets as almost a proxy trade on oil.”

The U.S. market for energy-related high-yield bonds has swelled to $201 billion from $65.6 billion at the end of 2007, according to Bank of America Merrill Lynch index data.

Bets on oil bonds suggest an ugly outlook for pipeline and exploration companies -- and all of the people they employ -- after they borrowed record amounts over the past several years.

Bond Distress

The extra yield, or spread, investors demand to own the typical junk-rated energy security has more than doubled since June to 7.44 percentage points above government debt, the Bank of America Merrill Lynch index shows. For context, the spread has averaged 4.82 points since the inception of the data in 1996.

Bond markets are suggesting the oil collapse will also spill over into the broader economy. Investors have been selling inflation-linked bonds, causing the $1 trillion U.S. market for the debt to lose $23 billion of market value this month, according to Pacific Investment Management Co. index data.

Traders are now betting prices will rise at a 1.5 percent annual rate over the next five years, down from a 1.67 percent estimate on March 3, according to break-even rates on Treasury Inflation Protected Securities. Both are below the Fed’s goal of 2 percent.

“Oil does interfere with the Fed’s critical message that low inflation is transitory,” Jim Vogel, an interest-rate strategist at FTN Financial, wrote in a note this week.

Rate Outlook

Yellen updated markets on her outlook Wednesday after concluding a two-day meeting with policy makers in Washington. She acknowledged that the oil rout has reduced the Fed’s expectations for inflation, while affirming her view that the impact from declining energy prices will “dissipate.”

The Fed dropped an assurance it would be “patient” in considering when to raise rates in preparation for an increase as early as June, yet reduced its predictions for growth, inflation and borrowing costs.

Bond investors are betting that Yellen will eventually come around to realizing that the impact of this oil slump isn’t so transitory, after all. If they’re right, inflation, and rates, could remain low for years to come.

(An earlier version of the story corrected the size of the loss in the eighth paragraph.)

Before it's here, it's on the Bloomberg Terminal.