Tuesday, December 13, 2016

What Rising Oil Means For Interest Rates

By Patti Domm
CNBC
December 13, 2016

As the world awaits a Fed interest rate hike this week, markets are watching the relationship between higher rates and spiking oil prices.

That was certainly a factor Monday and traders are watching to see if there's any follow-through on Tuesday, though oil came off its highs after a big morning surge.

"Interest rates and oil prices tend to move closely together. It's kind of geared to growth. The oil price hike over the last couple of weeks you could argue is supply related rather than demand. At least based on where oil prices are, interest rates are about right," said Jack Ablin, CIO of BMO Private Bank.

Oil was up more than 4 percent in early trading Monday, but futures settled up just 2.6 percent. The move was triggered after OPEC and non-OPEC members agreed to specific production cuts over the weekend. West Texas Intermediate crude futures ended the day at $52.83 per barrel.

On Tuesday, the Fed begins the two-day meeting where it is expected to raise its fed funds target rate by 25 basis points for the second time in 10 years. Analysts believe the increase is largely factored in by the markets at this point, and the surprise would be if the Fed did not raise rates. There is little data Tuesday, with just import prices at 8:30 a.m. and the NFIB small business survey at 6 a.m.

Oil was a headwind for stocks during its long decline, but the crude rally Monday wasn't much of a tailwind for equities, perhaps because of the influence on interest rates. The yield on the 10-year Treasury was 2.528 percent in early New York trading as oil was spiking, but ended the day at 2.47 percent. The 2-year yield has also been moving higher, and it is the shorter duration yields that are most sensitive to Fed action. It was at 1.13 percent late Monday.

The S&P 500 fell 2 to 2,256, while the Dow scored its 15th record close since the election on Monday. The Dow closed up 40 at 19,796.

"The one bullish argument is stocks have been cheap relative to bonds, but guess what? The 10-year is nearly 2.50 and headed toward 3," Ablin said. Bond strategists mostly expect the 10-year to remain in a near term range that would top out in the high 2 percent area at best.

Oil analysts do not expect a much higher price for oil in the immediate future. Citigroup global energy analyst Anthony Yuen said he expects WTI to be at $55 per barrel in 2017. Yuen said the agreement between OPEC and non-OPEC Russia and others lasts just six months, and the producers should stay with the cuts.

"The thinking is that OPEC will probably stick with it because you have the leaders shouldering the bulk of the cuts and they seem to be committed," he said.

Francisco Blanch of Bank of America Merrill Lynch, however, believes the OPEC deal could help push the price of West Texas Intermediate to $69 by the middle of next year.

Bond strategists have been keeping an eye on oil as a possible catalyst for inflation, since crude began edging higher on just talk of a producer agreement. OPEC's agreement pushed it higher, and oil jumped even further when non-OPEC producers came on board.

According to analytics firm Kensho, when the 10-year yield rises, the price of oil does too. Looking at 23 instances in the last 20 years, where the 10-year yield rose 50 basis points, the price of oil rose an average 8.9 percent. Since Election Day, the 10-year has moved as much as 70 basis points, and oil has risen about 17 percent.

During those same periods, the Dow has risen 4.8 percent on average. The Dow is more than 3.5 percent in the past month.

As for the stock market, Ablin said he's fairly cautious on the market and likes smaller and medium-cap stocks better than large.

"I think at some point, we're going to need some fundamentals to substantiate the expectations that are built in," he said. "I think there's some quick hit. If you could lower the corporate tax rate and do it quickly, that could be a bounce [for stocks]."

Ablin said there are some signs that investors are holding on to stocks expecting that capital gains taxes would also be reduced next year. President-elect Donald Trump proposes retaining the 20 percent rate but cutting the corporate tax rate to 15 percent.


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