Oil, High Yield, Correlations, and the USD Short Squeeze
December 15, 2014
Three year horizon: Oil and high yield showed a complicated and unhappy relationship with each other. Sometimes they moved with each other, but more often they trade inversely: as oil moves up yields move down. Not only did this correlated relationship vary directionally, the strength of this relationship varied as well. Check out the rolling 30-day correlations (in basis points) below. When an oil price rise was associated with a high yield sell-off, it was a macro-level risk-off event.
Late 2014 has been particularly volatile. We have seen particularly radical swings, reaching 3-year highs and then swinging to 3-year lows. The correlation is now -75%: when oil sells yield rise: this is risk-off. But keep in mind that these correlations swing positive to negative on a three month cycle.
The stormy relationship can be explained by QE and the resulting renormalization of monetary policy. First year, 2012, there was a tight but inverse relationship between oil prices and high yield bond yields. Oil price increases were associated with a decrease in yields. This is part and parcel of QE, where risk—any risk—got the bid. Sustained QE led to a big divergence in 2013 and most of 2014, as commodity markets and credit fared differently under the conditions of low interest rates and reduced/eliminated direct QE. Low interest rates are very credit-supportive, but commodities suffered by the phase-out of QE. As a result, oil was range-bound until QE ended.
Then the dollar began its rally and broke the range bound oil market. High yield credit didn’t care initially until it became clear that the oil price had a definite impact on credit risk in the energy sector as they imply compromised cash-flows. We’ve written in prior posts that the correlation between oil and USD is very stable, and current dollar levels imply oil in the mid-$50s. The conclusion is that if oil prices remain at these levels or degrade further, crude supply will tighten and prices will normalize. The implication is that the energy sector suffers a wave of BKs. A dollar decline will provide some relief, but without QE resumption, likely not enough to restore some enterprise viability.
Whenever you see these kinds of moves multi-s moves, established relationships break down. The breakdown of these relationships, typically called “arbitrage” when they are not, forces selling. Selling becomes contagious. This selling has created a feeding frenzy beyond energy companies. All of it is due to USD strength.
There is no doubt that the energy sector is not healthy. I maintain that the big risk for global credit is yen strength, meaning carry unwind. The big risk for commodities remains USD. The problem is that low rates have led everyone to funding in dollars and run up leverage. Essentially being short dollars, long everything else. The USD rally could force a short-squeeze that crushes everything under its weight.
The clearest way to postion for this is to anticipate who benefots by cheap oil. The benefits are in Asia.