A peculiar shift in a key oil market indicator is prompting Vanguard Asset Management to purchase protection against the risk of U.S. inflation remaining higher than expected for a longer duration. Since a fragile ceasefire agreement was reached between the U.S. and Iran, crude oil prices have fallen sharply, yet the decline in gasoline prices has not kept pace, causing the spread between them to widen to its highest level since 2022.
Ales Koutny, Head of International Rates at Vanguard's active fixed income group, stated he is closely monitoring this so-called "crack spread" for signs that refined product prices could rise again and push inflation higher. "We've never watched this indicator so closely before," Koutny said in an interview. "Because the crack spread is usually highly correlated with oil prices, it was often just a secondary indicator in the past. But now, the price movements of products like gasoline, jet fuel, diesel, and fuel oil are clearly diverging from crude oil prices."
While the crack spread is a fairly common metric in oil trading, measuring the difference between refined product prices and crude oil prices, it typically receives little attention from bond investors. The Middle East conflict has significantly reduced fuel output from global refineries, and ongoing Ukrainian attacks on Russian refining facilities have prompted Russia to ban diesel exports, both driving up refining margins. Despite the retreat in crude oil prices, the crack spread has continued to widen, making this anomaly a focal point for some bond investors.
"The question is whether this spread will normalize, or whether this low correlation will evolve into a more structural feature with implications for inflation risk," Koutny said. "These deviations could either reinforce or diminish inflation risks; both are possible, and the impact could be quite significant."
The two-year breakeven inflation rate, which measures the gap between yields on nominal U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS), has been falling over the past month and is now near its lowest level in nearly two years. This suggests the market expects U.S. inflation two years from now to be only slightly above the Federal Reserve's 2% target.
This trend has led Koutny and his team to establish long positions in short-dated U.S. TIPS, while also taking positions in breakeven inflation trades further out on the yield curve. They believe the market is underestimating the possibility of inflation remaining persistently above expectations.
This week, renewed Middle East tensions, following former U.S. President Trump's skepticism about the U.S.-Iran ceasefire deal, pushed oil prices significantly higher. The Vanguard team is also refining its models to incorporate various petroleum distillate products, in addition to crude oil, as reference indicators when assessing inflation risks.
Currently, traders anticipate that the Federal Reserve, the European Central Bank, and the Bank of England will each cut interest rates by 25 basis points before the end of the year, with expectations for further monetary policy tightening this year or next. Compared to the rapid surge in rate hike bets that briefly followed the outbreak of the U.S.-Iran conflict in March, current market expectations for further tightening have notably moderated.
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