Oil vs. the Yield Curve
Featuring Nick Colas
Published on: August 22nd, 2019 • Duration: 11 minutesNick Colas, co-founder of DataTrek Research, says investors may be making too much for the recent yield curve inversion. He believes that oil rallies have played starring roles in many prior recessions. In this interview with Alex Rosenberg, Colas analyzes the recent market volatility, breaks down some important economic signals, and presents a unique hedging strategy. Filmed on August 21, 2019.
ALEX ROSENBERG: Welcome to Trade Ideas. I'm Alex Rosenberg, here with Nick Colas, co-founder DataTrek Research. Nick, thanks for joining us today.
NICK COLAS: Absolutely.
ALEX ROSENBERG: So today, as we're recording this around mid-day, S&P up about 1% seems to be a pretty good day for the markets. As you look at these moves today, but over the past few weeks, really, what do you think? What questions do you think the market is trying to figure out and decide, as we see these big vacillations to the upside, and the downside?
NICK COLAS: The biggest issue the last call it 72 hours and will be the case for the next day or two is what is Jay Powell going to say at Jackson Hole? And Fed Funds Futures clearly, clearly think the Fed is going to cut rates by 25 bps at every meeting through the rest of the year. It's a very specific outlook in Fed Funds Futures. And it's really coalesced around that expectation in the past call it a week. Before then, people were thinking maybe a 50 some point or not. Now, it's very clear 25, 25, 25. Markets are setting up to want to hear that from Powell on Friday. Trouble is he's probably not going to say that.
ALEX ROSENBERG: Now, it's interesting, because when your colleague Jessica was here two weeks ago, she talked about looking for an expectation of a 50 basis point cut at the next meeting as one of the things you would want to see in order to know that the market was bottomed and that it was a dip to buy. So we're not saying that. What does that indicate to you about the path between here and that meeting?
NICK COLAS: Yeah, that's exactly right. And it tells me that we're still in for more volatility. I think the market said, okay, 50 is off the table, we get that. That's too extreme. But how about communicating to the market that you're there for the market by cutting rates consistently, and not being a one and done or a mid-cycle adjustment, the way Powell described it, at the July 31st Fed press conference. So markets are shifting, still hoping for some relief from the Fed. But at the same time, hardly the Fed's going to go that far out on a limb when things still don't look all that bad according to the data that they watch.
ALEX ROSENBERG: Now, I'm glad that we have you here. Because you're known, at least to those of us in the financial media community for finding different ways of looking at what's going on the economy of unconventional ways. I think you've looked at burger sales, you've looked at, I think plasma sales, people selling their own blood, in Google searches as well. What do those indicators tell you about where we are, if this is an economy where it's appropriate for the Fed to be continuing to ease?
NICK COLAS: Yeah, you're right. We look at the standard data. But we also spend a lot of time looking everywhere and anywhere for anything that might give a tell on the economy and find an edge on that topic. And the thing that we look at right now a lot is Google Trends. This is something that any one of your subscribers can do. Just go to Google Trends and you can see how many times a given word is searched for.
The two we look at most often right now is the word coupon and the word unemployment. Coupon indicates the beginning of some stress in household budgets, perhaps because somebody is not working as many hours or somebody has lost a job. And unemployment's a good leading indicator of when people begin to fear unemployment. And these were two things that began to tick higher ahead of the last recession, long before the yield curve inverted, long before anybody was talking about it. And it gave a nice about 6-month window where it was ticking higher, where you could say aha, there's something going wrong. There's something amiss in the US economy.
And so far, Google Trends for coupon and unemployment are both rock solid or declining. So again, shows, at least from that level, consumer confidence, we're not yet clearly going off a cliff.
ALEX ROSENBERG: And we had some retail earnings that were pretty- that surprised the market to the upside as well. So indications about the consumer, maybe it looked a little better now than perhaps a month or two months ago.
NICK COLAS: It does feel that way. And look, it should feel that way. We still do have very low levels on employments. We have some wage growth that we had in the last cycle, 4% then, 3% now, but still pretty good. Confidence should be going to be really worrisome if you had a lot of big retailers disappointed and miss.
ALEX ROSENBERG: On the other hand, the market signals have been less good. A lot of people learned what the yield curve was. Over the past week, I was watching the Sunday morning, politics roundtable shows and hearing people try to explain the yield curve was a little bit painful, I have to say. But as that's come to the fore as a potential indicator of recession, as a signal that's always worked, apparently, what do you make of that whole debate about the importance of it this time around?
NICK COLAS: It's an interesting indicator, and certainly has somewhat of a track record. At the same time, my personal view, it is super lazy to just look at the yield curve and say, aha, recession's coming, turn off the lights, sell your stocks and go home. There's so much more in the economy that matters than just interest rates.
ALEX ROSENBERG: So what are those some of the things that we're not looking at as much that perhaps we should?
NICK COLAS: Yeah, look, the key issue is oil prices. Because, yes, the yield curve has inverted ahead of every recession since 1973. But if you look at the change in oil prices, year over year, over the entire timeframe from 1970 to now, you will see that ahead of every recession, every single one, oil prices doubled over the course of a year, and sometimes a lot more. And going into the Saudi embargo in '73, oil prices actually went up by 500%. And then ahead of the Iranian Revolution in '79, same thing. When Iraq invaded Kuwait, same thing. Even in 2007, people forget, but oil prices hit $140 a barrel and had doubled over the course of a year.
So it isn't just enough to say, okay, we got the yield curve inverting, therefore, recession is inevitable. What we don't have is oil prices doubling. We don't even have oil prices going up, they're going down. If you ask the average person on the street, what's the Fed Funds Rate? They'd look at you like you have two heads. But if you ask them how much they pay for gasoline last week, they would know down to a nickel, and they would know the general trends.
So to my thinking, it isn't just the yellow curve, we have to look at fundamental factors as well. Oil prices are just as good an indicator of future recession risk as the yield curve and I think a lot more explanatory about how consumers really behave.
ALEX ROSENBERG: This is a very hard question, but help us explain the relationship between the shape of the yield curve and oil. Is it not coincidental that the yield curve tends to invert as we see oil prices spike?
NICK COLAS: Yeah. No, I'll put it this way. An inverted yield curve is like a lot of dry tinder sitting in a fireplace, and the spike in oil prices is the spark that actually gives us the flame for a recession. So right now, yes, a lot of dry tinder around. And that's why the market's volatile, and rightly so. I don't want to dismiss what's going on. But at the same time, if you want to tie it to an actual fundamental issue that matters to everybody, oil prices, then to look at, oil prices simply aren't providing that spark right now.
ALEX ROSENBERG: And it seems to me at least, that you always hate to say that we can't have a geopolitical event that sends oil prices. You hate to make predictions about this can happen because it's easier to remember those. But it seems to me that we're just in a different world when it comes to oil, where the Strait of Hormuz is in the headlines again, and yet oil prices don't care, the market doesn't care. It's a geopolitical story rather than an economic story, just because the US makes so much more oil than it used to. I guess, when you look at oil, specifically, if that's going to be the oil that lights this fire up to continue the metaphor, do you see anything that would indicate that oil prices would spike? And that would set this tinder ablaze?
NICK COLAS: Yeah, you got the right. I think you've got the right sentiment about it, which is you can never say never. And it certainly could happen and the Middle East has been a geopolitical mess for my entire lifetime, 50-plus years, and I don't think it'll change over the rest of my lifetime. So is there a lot of risk to it? There always will be. But you're right.
Oil production in the US has roughly doubled over the past decade. So we have our brand new technology that gives us a better supply. That does at least alleviate the worries about availability, which really is what killed the economy back in '73 and '74, wasn't just prices, but you couldn't actually buy this stuff. So now, we have a better setup. It's not a foolproof setup, but it's a better setup.
And the one other thing I'd say is look at energy stocks. Energy stocks, even five years ago were 10% of the S&P. Now, they struggle to hold 5%. That group is super beaten up. So in terms of thinking about how you hedge and how you think about risk, one thing you might want to be stay long, at least neutral weight is energy. Because then, if you do get something bad that happens and the rest of the market pulls in, energy stocks will at least finally start to work. 5% of the S&P I think is a record low. I don't think it's ever been lower, and maybe it goes to three but if things do spark up, might as well goes to 10 again.
ALEX ROSENBERG: If you were concerned, what other sector would you pair against that as a sector to maybe underweight?
NICK COLAS: Oh, consumer discretionary, tech, anything at top of the cap table basically on the S&P is going to whacked. Correlations between the different sectors run heaviest in technology right now and in consumer discretionary. You might also look at staples as defensive that's more of a yield play, energy is that geopolitical hedge, gold obviously, should work as well.
ALEX ROSENBERG: It's interesting. We've heard a lot of ideas for hedges recently as people are worried about this chance of a recession and we've heard about euro/dollar futures and heard about volatility and gold certainly has come up as well, but going long energy as a way to- almost, I've heard of energy as a revenge trade where you go long energy in case your oil prices go up. But as a way to hedge against the broader market is very interesting. So Nick Colas of DataTrek Research, thanks for bringing it to us here in Real Vision.
NICK COLAS: Thank you.