Two “Data” items today:
Topic #1: The correlation between WTI oil prices and price returns for the S&P large cap Energy sector (symbol: XLE). Let’s start with some background data:
- Since 2010, the 50-day correlation between daily changes in WTI crude prices and daily returns for the S&P 500 Energy sector has averaged 0.59. That is an r-squared of 35 percent, lower than one might think.
- Energy stocks can – and often do – decouple from oil prices, which is why the long-run mean correlation between the two is so low. For example, correlations were below 0.44 (1 standard deviation) in 2011, through most of 2013 – 2014, 2017, late 2018, and 2020.
- The current 50-day trailing oil price/Energy stock correlation is 0.45, right on the 1 standard deviation downside level of 0.44.
Comment: since WTI first crossed $90/barrel on February 11th during its recent rally, crude is up 14 percent, but large cap Energy is only up 9 percent, and on several days one asset zigged while the other one zagged. That’s another way to express the same issue noted in the analysis above: crude and Energy stocks are not trading together as much as they typically do.
Now, exactly why are Energy stocks not trading more in line with crude prices? The 2010 – present history says this can happen for one of two reasons:
- When equity sector correlations are high due to macro concerns, as was the case in 2011, late 2018 or 2020. In such situations, Energy stocks will trade in line with the broad market rather than on sector fundamentals.
- When markets do not believe current oil prices are sustainable. That’s what happened in 2013 – 2014, when oil/Energy stock correlations were reliably below 0.40 even though WTI was trading in a tight band around $100/barrel.
Comment: the current investment environment is a hybrid of these 2 points. Energy is the only sector up on the year (+34 pct) and that has made it a very crowded trade, one where investor interest ebbs and flows on news headlines as much as crude prices. On top of that, WTI has been spiking rather than grinding higher. That fits the second piece of the paradigm – markets don’t believe the current move is sustainable.
Takeaway: unusually low correlations between Energy stocks and crude prices tell us two things that net out to a still-bullish story for stocks in the sector:
- First, investors don’t trust the recent rally in oil. Fair enough – this market is a hot mess right now, between Russia-Ukraine and potential new output from Venezuela and even Iran. High prices also risk creating demand destruction that might even tip the global economy into recession.
- Against that, however, large cap Energy is the cheapest group in the S&P 500 (13.3x vs. 18.5x for the index), has excellent upside earnings surprise potential, and a solid dividend yield (3.2 percent).
- We would not be surprised to see XLE drop 10 percent from here if global equity markets weaken further in the near term, but we still like the group for a 1-year holding period. There are not many inflation hedges in US equities, but Energy is certainly one of them.
Topic #2: Fed Funds Futures markets were actively repricing their expectations for 2022 Fed rate policy today. Given that the next FOMC meeting starts tomorrow, these are essentially the market’s best guess for not just Wednesday’s rate decision but also the tone of the communique and Chair Powell’s press conference comments. Here are the latest odds, as of 3:30pm East Coast Time today:
March 16th meeting (no change, 25 bp is a lock)
- A 25 basis point hike is still a sure thing according to Futures, at 98 percent odds.
May 4th meeting (higher odds of a 50 bp hike, now +50 percent)
- The odds of a 50 basis point hike at this meeting moved higher today, to 53 percent, from 42 percent on Friday and 29 percent a week ago.
- The probability of a 25 basis point increase has dropped to 46 percent from 56 pct on Friday and 67 pct a week ago.
June 15th meeting (odds rising of 50 bp in May AND June, now 27 percent)
- The odds that the Fed will raise rates by 25 basis points in March, May and June have fallen in the last week, from 52 percent to 23 percent today.
- The probability of the Fed raising rates by 50 basis points at BOTH the May and June meetings have risen to 27 percent from 7 percent a week ago.
- The chances that the Fed moves by 50 basis points at EITHER the May or June meeting stand at 50 percent today, up from 38 pct a week ago.
December 14th meeting (little chance of 50 basis point increases at 2H 2022 meetings)
- Futures put the highest odds that Fed Funds end the year at 1.75 – 2.00 percent, at 35 percent. The easiest path to that end point is 25 basis point bumps at every meeting between now and the end of the year.
- The odds of Fed Funds being higher than that (implying at least one hike of 50 basis points) stand at 36 percent. That is lower than the 50 percent odds for a 50 bp bump at the June meeting. If the market thought 50 bp hikes were likely to also come in the back half of 2022, these would be higher.
Takeaway (1): Fed Funds Futures are expecting to hear that the FOMC is ready to move by 50 basis points at a meeting in the first half of 2022, and maybe two meetings, even if Wednesday only sees a 25 bp liftoff from zero. Given current inflation trends, that is a logical assumption.
Takeaway (2): just remember that the Federal Reserve usually hikes rates when equity market volatility is low, rather than very high as it is right now. Going back to 1990, the average VIX reading on the day the FOMC raised rates for the first time after a recession was 17.4. Today we are at +30.