Peter Cecchini Comments: These prices are insaaaaane!

December 16, 2014, Reuters

It’s time to pause and take stock of the effect of the oil slump and dollar rise on markets, rather from just marveling at it. Market-watchers tend to look at one asset and attempt to use it as a guide for what will happen in another.
 
It’s not enough to say that lower gas prices are good for the consumer. The wider high-yield spreads, particularly those sold by energy companies, serve as a warning for equities. The spreads narrow the risk premium between corporate debt and stocks and make the equity market look a bit less attractive.
 
With that in mind, here are a bunch of questions:
 
Has the massive sell-off in oil fundamentally changed the economic equation in the United States and around the world so that investors need to think differently about equities going forward? Does the decline in bond yields to levels not seen in a year-and-a-half and a sharp fall-off in inflation expectations mean that investors need to rethink the outlook for economic growth in the coming year? How do these affect the Federal Reserve and the belief that it will remove the “considerable period” language regarding plans to keep rates at rock-bottom-Crazy-Eddie-style levels?
 
There are quite a few cross-currents in play: a big sell-off in high yield bonds, volatility in crude oil, and the sell-off in the ruble that has hit the Russian stock market.
 

A screengrab from one of Crazy Eddie’s commercials (Source: Wikipedia)
 
Taking those questions one at a time, the falloff in oil has wwwuced a massive rise in the oil VIX (similar to the stock market’s VIX) that rose to more than 50 points by Friday, its highest since late 2011.
 A screengrab from one of Crazy Eddie’s commercials (Source: Wikipedia)
The oil VIX can tend to be more jittery on the upside than the S&P VIX, because one is based on options prices that are looking at the movement of a combined 500 stocks while the other is based on one instrument (U.S. crude).
 
Still, Peter Cecchini of Cantor Fitzgerald points out in commentary that the two follow each other closely, and the big jump in oil volatility would seem to imply something similar could occur in the stock market.
 Now the supply issues are a complicating factor, because it’s part of the equation when looking at the move in oil. If the demand side is what’s pushing oil lower, that’s another story, and that bodes ill for equities too.
 
Either way, it’s a good reason to expect more bumpiness in stocks in coming weeks, if not months, until some stabilization level is reached that makes investors comfortable.
 
Oil also feeds through to the credit markets where high yield spreads, as measured by the Merrill Lynch High Yield Index, have risen to levels not seen since a brief increase in June when markets also hit a bit of a rough patch.
 
Merrill’s high yield index is at about 521 basis points more than Treasuries, which are still historically slim, but at least packing in some extra sensitivity to the risk question. The Merrill High Yield Energy Index, meanwhile, is at about 780 basis points over comparable Treasuries, having more than doubled since the end of August.
 
Some of this, as Steven Antczak of Citi points out in commentary, comes from people getting out of crowded positions in the oil and high yield energy sectors, so some of the panicked selling is gone, and should stem some declines. He also points out that some of the high-yield debt issuers may not be able to cope with oil prices this low, though the debt does not tend to mature for a couple of years, so don’t expect a wave of defaults just yet.
 
“Crowded long positioning in both the oil market and the high-yield energy sector may have resulted in a more dramatic fall in valuations than near-term fundamentals warrant,” he writes, saying short-covering rallies could be in store for oil and high-yield bonds.
 
That might extend, for that matter, to energy ETFs, as crowded positioning like this tends to feed on itself across asset classes. As for the Fed, Citi and others, still expect them to remove the “considerable” language. The Fed isn’t going anywhere – any rate increase that might happen isn’t going to be for some time to begin with.
 
Oil’s declines may be transitory and at a more stable level, even as the decline is going to hit some economic activity in some of the oil-wwwucing states. It won’t be enough trouble for the Fed not to take the very incremental step of at least acknowledging economic improvement.
 
Will the equity market have a bit of a hissy fit over that? Maybe. But then again, the market could also take it as a sign that the Fed is accepting what everyone knows – that the U.S. has seen enough growth to end some of its extraordinary efforts.