Recovery, then inflation to govern oil links

 

Oil's positive correlation to equities has been the most striking in decades, but it will end, probably when economic recovery becomes a reality rather than an expectation.

The more lasting but still provisional relationship could be the negative correlation between the dollar and oil in the event rising inflation pressures the U.S. currency and inspires the purchase of commodities as an inflation hedge.

"Long term, I would say oil is a great hedge against inflation" said Chris Jarvis of U.S.-based Caprock Risk Management.

For now the sharpest focus is still on trading in relation to equities as "the best barometer of how bad it is or what kind of growth we will return to", he added.

"Eventually, that will decouple and I think you are already seeing that to some regard."

Some say oil and equities have simply been reacting to the same data, but however accidental the link, the convergence has been the most marked since the 70s, analysts have said.

Now as then, a deep recession has followed a period of very high commodity prices, which aggravated the economic downturn.

Equities and oil diverged when the oil price bottomed from mid-December to early March as it focused on collapsing demand and excess supply. Since early March, they have converged, both moving up or down depending on whether traders are anticipating economic recovery or prolonged recession. 

From a December low of $32.40 (19.21 pounds), U.S. futures hit $73.38 at the end of June, their highest this year, but only around half the record of $147.27 struck in July 2008.

The Standard & Poor's 500 Index .SPX hit a high for this year of close to 1,000 in July, recovering from a multi-year low just above 666 points in March, while the dollar index .DXY has been sliding from this year's peak hit in March.

FORWARD-LOOKING VERSUS ACTUAL

While equities tend to be mostly forward looking, commodity markets factor in actual fundamentals of supply and demand, analysts argue, although they can also look to future demand.

They are likely to be at their most forward-looking during a downturn as macroeconomic expectations of recovery, significant for oil markets as indicators of future fuel use, become tantamount to an extra oil market fundamental.

"The only reason behind the correlation has to do with macroeconomic uncertainty. Once the path for recovery is clear and well-defined, correlations will break" said Francisco Blanch of Banc of America Securities-Merrill Lynch.

A consequence of macroeconomic uncertainty has been a massive flight of capital away from riskier assets, such as equities and oil, and then back towards them depending on the economic outlook.

During the unwinding, money can move towards the dollar as the ultimate reserve currency, which then weakens as economic confidence grows and inflation looms as an unwelcome next stage.

Inflation would be expected to weigh on equities, but commodities, as a driver of price rises, would logically be bought as an inflation hedge. 

At the same time, inflationary pressure would depress the U.S. dollar and spur buying of dollar-denominated commodities, such as oil.

Traders are already said to be buying commodities for future delivery in anticipation of inflation, which many view as an inevitable consequence of pumping huge amounts of money into the system and the racking up of government debt.

"For the oil markets, the dollar and inflation hedging is the most concrete and most important of the non-fundamental drivers" said Mike Wittner of Societe Generale.

"Logically, the dollar inflation story makes more sense because of the macro-economic reasons behind it. Liquidity is being pumped into the market. Liquidity can ultimately be an inflationary pressure once the economy is growing again."

If inflation could be one way to end the equities link, another would be if stock markets were to push oil to the point where it damages economic growth.

The most powerful circuit-breaker of all would be a really compelling fundamental and for some, that is long overdue.

Peter Beutel of Cameron Hanover in Connecticut, the United States, said prevailing market conditions had prevented necessary activities, such as locking in heating oil costs ahead of winter because prices have already been driven too high.

"I understand the theory, but I don't care for it" he said of taking the cue from equities and alternatively risk aversion or appetite for risk.

"To my mind a lot of index funds have taken a perfectly good oil market and turned it into a tag-along little sister to equities and currencies."