As pressure mounts to lift lockdown restrictions, the oil market, yield curve and inflation expectations will provide signposts on the road of recovery.
The slide in West Texas Intermediate crude oil the US benchmark to a pitiful low below $US15 a barrel in Asian trading on Monday speaks to a slump in demand so savage as to outpace production cuts from the world’s three biggest producers.
While policymakers would usually cheer an oil price slide as a boost for consumers, the lift in consumer spending power from lower prices at the bowser doesn’t exist in a world of essential travel only and social distancing.
But more worryingly, it has exposed the overleveraged balance sheets of many US shale producers. Banks and bond owners are anxious as credit downgrades signal that this downturn will be an extinction event for some producers.
The success of producers in reining in a glut that OPEC estimates will average about 15 million barrels a day in the second quarter will be reflected in the futures curve.
In its latest oil market report, OPEC called it a “super contango” a situation where futures prices are significantly higher than spot prices. Spot prices are depressed because of the glut, which reflects a shortage of storage for oil that continues to accumulate.
With Brent oil the international benchmark trading at $US27 a barrel and December futures trading around $US36 a barrel, there is some way to go before a sense of normality returns to the market.
A rebound in global economic activity would help suck up some of the excess from the growing lake of unwanted oil, and that appears to be priced in yield curves.
While hopes of a V-shaped recovery retreat with every day of lockdown, there is hope that an easing of restrictions combined with the one-two punch of massive monetary and fiscal stimulus will deliver a U-shaped rebound later this year.
Yield curves, measured by the difference between the yield on two-year bonds and 10-year bonds, have steepened from their March lows in the wake of policy intervention.
The Australian yield curve has steepened to 56 basis points from 20 basis points on March 9, while the US yield curve has steepened from 11 basis points to 43 basis points.
A yield curve that goes up and to the right is traditionally viewed as a signal of stronger growth to come. While recession stalks many economies now, a steepening of the curve would provide a sign that global markets are growing more confident about the traction of any recovery.
Tying together stronger oil prices and an economic recovery would be inflation expectations.
Ten-year break-even rates are a market-based measure of longer-term inflation expectations, as they measure the difference between the yield on a nominal government bond and an equivalent inflation-indexed bond.
Break-even rates have rebounded from their March lows. Australia’s 10-year break-even rate has climbed to 0.68 per cent from 0.23 per cent on March 23, while the US break-even rate has increased to just over 1 per cent from 0.55 per cent on March 19.
While the threat of deflation has been averted by monetary and fiscal policy, it could be some time before inflation gets anywhere close to central bank targets given weak demand, excess capacity, and the hit to both business and worker pricing power caused by the COVID-19 crisis.