Oil Link to Credit Turned by Easy Cash: Analysis

(Bloomberg) -- The relationship between oil prices and corporate-credit spreads has loosened over recent quarters as easy monetary policy keeps risk-asset spreads anchored, writes Bloomberg strategist Simon Ballard. But energy market price performance has been constrained by weakening global growth assumptions, raising the question of whether the correlation will continue to fade or if one of the two data series will fall back into line with the historic trend.

An analysis of the 120-day correlation between WTI crude oil and European high yield credit shows that the negative coefficient has been steadily eroding over the past year. Since June 2016, the correlation has risen back toward zero and now sits at its least-correlated level in around two years. The last time the relationship between oil and corporate credit was in positive territory was 4Q2014/1Q2015, when spreads recovered from early 4Q2014 widening on Greece debt and German macro uncertainties, and the oil price weakened with deteriorating global economic growth assumptions. 

Historically, the price of oil has been viewed as a proxy for economic growth and by extension, the state of corporate credit fundamentals. Rising global growth has the broad impact of pulling the oil price higher and implies improving corporate credit quality, and vice-versa.

The shift in correlation between oil and European and U.S. credit over the past year, back towards a positive relationship, may result from Europe and the U.S. being net importers of oil. The decline in the oil price since 2014 has fed an improved import cost profile, underpinning credit fundamentals and so has been accompanied by tighter credit spreads.

Moreover, looking at a shorter-term time frame, Bloomberg data highlights the increased volatility between high-yield credit (iTraxx Crossover index) and the price of oil. While European high yield credit has continued to tighten against the backdrop of accommodative central bank monetary policy, the oil price has gyrated over the past month or so as OPEC countries have discussed and then agreed on oil production cuts to support the oil price, albeit paring some of those gains in the past week. While OPEC production caps have underpinned the oil price recently, the latter remains susceptible to the global macroeconomic outlook. Any renewed deterioration in global growth assumptions could tend to undermine the oil price again.

Furthermore, the ECB gathers for its next monthly governing council meeting on June 8, the statement from which investors will scrutinize closely for any hint of shift toward monetary policy normalization. A higher yield structure could dent risk appetite and fuel a re-steepening of the credit quality curve and wider spreads, which would reassert positive correlation to the higher oil price.

Overall therefore, while the negative correlation between energy prices and corporate credit risk has diminished significantly over the past year, there are mitigating factors to at least partly explain this. Central bank quantitative easing remains instrumental in supporting risk appetite and artificially anchoring credit spreads, any move away from which could see spreads correct wider and positive correlation reassert itself with a rising oil price.

At the same time, rising oil prices simply as a consequence of OPEC production cuts rather than improving macroeconomic growth conditions may just be a short-term phenomenon. Failure of oil producers to adhere to production quotas over the coming months could pressure the oil price lower again, in turn also reigniting positive correlation with well anchored credit spreads.

• Simon Ballard is a credit strategist who writes for Bloomberg. The observations made are his own and are not intended as investment advice

--With assistance from Nancy Moran

To contact the reporter on this story: Simon Ballard in London at sballard20@bloomberg.net.

To contact the editors responsible for this story: Hannah Benjamin at hbenjamin1@bloomberg.net, Chris Vellacott