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January 25, 2018

Narrowing debt spread and boom and bust cycles

Narrowing debt spread and boom and bust cycles

Oil speculations helped US oil firms to cover 10% of drilling costs

The collapse of oil market started in the middle of 2014 and turned to recovery in the beginning of 2016 year when priced finally returned to upward trajectory. For this time United States managed to accumulate reserves and sell them in profit later.

Active stage of amassing crude reserves started in October 2014 and continued till the end of March 2017. Enjoying underpricing United States bought 211.2M barrels with average price of $50 per barrel. About $10.6 billion were spent for buying cheap oil.

The selloff of stockpiles started in April 2017 and has been continuing so far. For this time United States got ride of 151.6M barrels, netting $7.9 billion revenue. There are 59,6M barrels left in tanks worth 3.9 billion dollars at current prices and selling them now oil traders would reap $1.3 billion net profit.

Of course this amount is not so large relative to whole total oil industry in the US, but comparing it with exploring and drilling costs in 2016 ($11.4 billion) it amounts 10% from those costs what could significantly help oil companies to sustain after the crash. Also besides of oil firms speculating on oil swings investment banks could also be beneficiaries from this activity, which rented tankers to store oil, hold it and then sell it for higher prices. Holding those barrels further may yield even higher profit.

US debt market experiences significant changes – an U-turn happens after decades of downward trend in Treasury yields. But why it can be dangerous?

Treasury yields has been declining for more than 30 years. The trajectory was strictly downward which briefly reversed only during mortgage crisis in 2006-2007 but then returned to global slump.

Fixed income market bears more significance than stock market because of higher sensitivity to risk. Therefore we can observe the change of core trends firstly on debt market and then on markets with higher yields.

Rising yields means a selloff of debt issued earlier as investors seek for higher yields. From the summer of 2016, Fed interest rate on 10-year Treasuries doubled from 1.3% to 2.6%. As the Federal Reserve took path of normalizing rates, bond price declines as the discounted value of future coupons decreases. But what rises most concerns is reshaped term structure with narrowing spread between 10-yr and 2-year government debt. It means rising demand for safety (fixing cashflows for long term future what drives demand for long-term bonds higher) with worsening near-term risks what leads to increased selloff of short-term debt.

History shows that most of US recessions were preceded with flattening yield curve (narrowing spreads between long-term and short-term bonds):

Still US government rolled out tax relief measures while Fed set to rise the rate further what can potentially hamper stock market rally, causing abrupt change of expectations. Is the narrowing spread a reliable indicator of looming tragedy? Leave your opinion in comments.

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