Rising Crude Oil Prices May Start Putting Upward Pressure on Bond Yields

In more normal times, the direction of commodity prices, and oil in particular, had an impact of the direction of bond yields. That because oil is viewed as an early barometer of inflationary trends. A falling oil price (along with other commodities) was disinflationary which boosted bond prices and lowered bond yields. Rising oil had the opposite effect -- falling bond prices and rising yields. Rising oil prices often prompted the Fed to raise rates to combat the threat of inflation. That's not necessarily the case now, but some semblance of those old relationships may still hold. Chart 1 shows the 10-Year Treasury yield (green line) and the price of crude oil (black line) falling together between 2014 and the start of 2016. That makes sense since falling commodities presented a deflation threat which encouraged global central banks to lower interest rates. One of the factors holding the Fed back at this point is dangerously low inflation. Rising oil prices may start to change that thinking. The boxed area to the bottom right shows the price of crude bottoming in February and trading nearly 80% higher since then (while bond yields continued to drop). A big divergence now exists between the two markets. In my view, that increases the odds that rising oil prices (and higher commodity inflation) may start to boost bond yields.

Yesterday's message showed the Energy SPDR (XLE) rising to the highest level in a year in anticipation of higher energy prices. Those higher prices are already in the inflation pipeline. The black bars in Chart 2 show Light Crude Oil (WTIC) (through Thursday) moving closer to the "neckline" drawn over its October/June highs. A move above that resistance line would complete a "head and shoulders" bottoming formation that started forming last August. [A H&S forms three bottoms with the middle "head" (in February) lower than the two surrounding "shoulders" (last August and this August). That's a very bullish pattern. The shaded area plots the CRB Index (of 19 commodities) to show that most commodities are also rising. That's potentially inflationary. If bond bulls aren't worried yet, they will be if crude oil achieves a bullish breakout. That would also catch the attention of the Fed.

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