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SPI Management Newsletter 06.10.23

Bond Market Upheaval Challenges Economic Stability

Rising long-term interest rates have hit a 16-year peak, casting doubt on the anticipated smooth economic trajectory, especially given the vague reasons behind the increase. Although the Federal Reserve has been elevating short-term rates for 18 months to counter inflation and decelerate the economy, the recent rapid rise is concerning. It coincides with a slight dip in inflation and signals from the Fed that its rate hikes might soon end.

The 10-year Treasury note yields have ascended to 4.801%, the most elevated since the 2007 subprime mortgage crisis. Consequently, stock indices like the Dow and the S&P 500 experienced significant drops, erasing their yearly gains. If these heightened borrowing costs, paired with a stock price dip and a stronger dollar, persist, both the U.S. and global economies could face slowdowns in the coming year, also posing financial-market breakdown risks.

A blend of anticipated robust U.S. growth and fears regarding substantial federal deficits possibly pressuring investor capacities seems to be the cause. Last year, the growth in Treasury yields was driven by the Fed's policy and inflation concerns. Now, however, different factors are at play, including diminished demand for Treasurys from various sectors.

Economists suggest that the term premium, an extra yield demanded by investors for long-term assets, might be rising, marking a shift from the previous decade's financial environment. The U.S. government could also face mounting borrowing costs, as the public debt has surged to approximately $26 trillion recently. Higher borrowing costs are pushing mortgage rates upwards, which could suppress asset prices, investments, and economic activities. Notably, the S&P 500 has lost about 8% since early August, and the U.S. dollar has appreciated against other currencies.

The bond and stock markets' recent behavior is surprising many investors. Some expected a negative correlation between stocks and bonds to return as the Fed's rate hikes concluded, but that hasn't been the case.

Oil Faces Steepest Weekly Decline Since March Amid Economic Concerns

Oil prices are on a downward trajectory, registering the steepest weekly dip since March. This decline stems from heightened global economic apprehensions that obscure future demand predictions. This week's slump in oil prices has been further aggravated by the strengthening US dollar and a notable increase in bond yields.

West Texas Intermediate (WTI) managed to hover over $82 per barrel after reaching its lowest point since the end of August this past Thursday. For the week, the US crude benchmark recorded a decline of over 9%, with significant losses particularly observed on Wednesday and Thursday. This abrupt turnaround has amplified market volatility indicators.

A combination of reduced US gasoline consumption and an uptick in gasoline stockpiles contributed to the oil price drop this week. These developments triggered discussions on whether the prior surge in prices was negatively impacting demand for the product. However, financial giant Goldman Sachs Group Inc. believes these concerns might be exaggerated.

Crude oil witnessed an impressive rally in Q3, majorly credited to OPEC+ leaders like Saudi Arabia and Russia, who curtailed supplies causing inventories to drop. However, over the past ten days, macroeconomic anxieties have reversed this positive trend. Despite this shift, both Moscow and Riyadh have reiterated their determination to maintain reduced output levels until the close of the year. Additionally, Saudi Arabia has elevated its official sales prices.

Factors like the ascendant US dollar, which renders commodities costlier for a majority of purchasers, have further driven the oil sell-off. Moreover, the pronounced surge in bond yields could potentially undermine economic expansion by elevating borrowing expenses for both consumers and corporations, which could in turn impact energy demand.

Indicators from the crude market timespreads this week point towards a slight relaxation in conditions. The WTI's immediate spread — the gap between its two closest contracts — stood at $1.51 per barrel in backwardation, indicating a bullish trend. Nevertheless, this figure has receded from nearly $2 per barrel just a week prior.

Adapted from WSJ, FT, NYT, Reuters, CNBC, Bloomberg

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