If oil prices stay low, real interest rates should start to rise. If, indeed, real yields do start to rise, it matters for global investors since US government asset prices are a floor for many markets. In the round, it will tend to move capital from low yielding and carry-trading activities to high return ones. Why would you put up with a few percent yield on a real estate asset if the US government is paying the same return net of inflation and no risk?
A favourite chart of mine is the regression of oil prices against the yield on US TIPS. It shows a clear and significant inverse correlation. That is, real yields are high when oil prices are low and vice versa. Real yields were above 4% in the late ’90s, when oil was down towards US$10, and they started falling as oil prices rose through the early and mid noughties. During the financial crisis, oil prices fell as real yields rose and then this reversed when oil prices recovered while real yields became negative. It is noteworthy that yields started rising a little before oil prices started their recent fall.
(TIPS are US Treasury Inflation-Protected Securities, the equivalent of indexed linked gilts. If you own a TIP, the US government pays you inflation plus a yield. This yield is therefore a real yield since it comes on top of inflation.)
The question is how are oil prices and real yields linked. My view is that it is all about surpluses. If oil prices are high, it generally means that oil producers are accumulating surpluses – Russia, Gulf states etc are receiving dollars for this oil. They have to re-cycle this surplus back into the oil-consuming countries. The problem is that it is, for a bunch of reasons, very difficult efficiently to re-invest that capital back into productive activities in the oil-consumers.
First, the oil exporters worry that the good times will not last so they put some capital in central bank reserves, which tend to be invested in safe, low yielding US and European government debt. Second, it is just plain hard for a few people sitting in the Gulf, smart and well-intentioned though they be, to decide the best place to invest money. Third, some of the surplus anyway ends up in unproductive outlets, such as luxury assets. Finally, there are high transaction costs for oil exporters to re-invest in oil consumers. There are lot of intermediaries along the route travelled by the re-cycling dollars all of whom have to be paid.
Consider the alternative. If there were low oil prices, there would be no surpluses. Rather than lots of US dollars ending up in a few hands in the oil producers, they would end up in the oil-consuming nations spread among many hands. All other things being equal, these dollars are more likely, in this fashion, to be more efficiently deployed.
In fact, the oil surpluses are a subset of the wider surpluses that were accumulated by the big exporters, including Germany and China, during the 2000s. The Chinese and German trade surpluses had an energy component. The petrodollar surpluses were not just about Western demand. China was importing oil in order to manufacture goods to sell to the West and still accumulating huge net surpluses. The strong negative correlation between oil and real yields arises not just from the inefficiency generated by oil surpluses but from the inefficiency of the web of imbalances in the global economy. Just imagine how difficult it was for the central bank of China to re-invest the trillions of dollars of reserves that it had accumulated.
These global surpluses are in decline. China is restructuring of its economy from production to consumption and Germany is unable to sell as much as before to the Eurozone periphery. So, to some extent, the fall in oil prices is an aftershock of falling trade imbalances but it is a useful marker for this broader trend and what it means, in due course, for real yields.
The Oblique View 