Is the next financial crisis around the corner? I know, it’s a fashionable question to ask and one that everyone’s got an opinion on. I don’t have one, but now you’ve clicked through to our website I shall reward you with some prose – some dross about something that’s concerning me to do with oil and a little musing on market sentiment. CDS at the ready!

Oil

For some reason everyone gets all up in their carriages about his one. Yesterday I noticed an article in the FT about March’s explosion in demand for US Energy high yield bonds. Fixed income investors are rewarded based on default risk, so high yield corporate bonds (also known as ‘junk’ bonds) are more risky than government bonds like US Treasuries. Energy high yield, well, that’s a whole different ball game.

The financial crisis of 2008 came about essentially due to untethered, excessive risk taking. Are we seeing excessive risk taking in the oil space about now?

Consider the default rate in the US high yield market. In the month of April, defaults on US high yield bonds were $14B (as at 14 Apr). That’s almost as much as for the whole of Q1 ($15.7B). What’s more, the FT also reports that more corporate debt was downgraded to ‘junk’ status in Q1 this year than in the whole of 2015. Yet demand for the highest yielding bonds – Energy – continues to tick higher, just like the oil price. Could this be another case of ‘dog sh*t wrapped in cat sh*t,’ a la Big Short?

Good question. The 2016 collapse in Energy bond yields (reflecting a sharp ‘rise in demand’) could merely be down to profit taking by those who have been short the market – they already called the dog sh*t back in late 2014 (the cats hadn’t got to it just yet). In that case, it’s not so much high demand as mere cashing out.  Investors may be getting out of the market, not into it, but they’re still acting on the assumption that the oil price is heading higher.

OPEC is past its ‘use by’ date

Negotiations between the world’s biggest oil producers have failed to agree on any action to curb production – in fact, OPEC’s infatuation with market share is destroying its credibility as a coherent organisation. However, perhaps the OPEC comedy show is also indicating a loss of control. If pure market forces are allowed to take over, maybe that’s a good thing?!

It’s worth noting that crude prices are not even near break-even levels currently, while US shale producers still look poised to start drilling as soon as the oil price goes above $50. When they do that, supply will increase; Saudi Arabia will push crude prices back down again, pushing the frackers back out of the market…again. Repeat.

Note also that the markets would be happy with mere oil price stability. That gives the oil majors and other companies a container into which they can grow – or shrink! So it may not be all that bad after all.

Currently though, the only things supporting oil add up to not much more than hope and a weak US Dollar. People buying high yield energy sector bonds and those going long of oil must be pretty confident about the future then. This is exactly when you need to start questioning their logic as once everyone’s invested, they’ve got no more to invest. Buying pressure falls off and prices reverse.

Sentiment indicators

The VIX volatility index, a measure of implied volatility, is currently lower than it was last June. A low reading implies low volatility which is a characteristic of a bull market. The reverse is true for high VIX readings. When the VIX turned back up in June 2015, the UK 100 began its long journey south. It’s perhaps a concern that the UK blue chip index has not regained its May ’15 record highs while the VIX has broken its own May ’15 levels. In a sense markets could be even more complacent today than they were back then.

Recent daily data from the Chicago Board Options Exchange verify this: A slight bullish bias in sentiment as regards equity markets, yet a rather alarmingly bullish bias on the VIX Volatility Index – remember that higher readings equal more volatility? Those trading the VIX mid-April are betting on just that.

Yes, yes, but is the next financial crisis around the corner?

Are you kidding? We’re still in the last one! But if you mean ‘is the next stock market downturn just around the corner?’ Then the above should give you food for thought.

Augustin Eden, Research Analyst (21 Apr)