Monday, November 12, 2012

Stock Markets and Oil part III: Post-1971 Recessions

Recessionary Trends
Counting the early-1980s recessions as a single recession, all five major post-fiat recessions have either been caused by or coincided with rising oil prices; three out of five have been caused by or coincided with a deflating housing price index.  Can it be that recessions have become predictable or even manageable?
A highly modified housing price index (average sale price divided by personal income per number of workers of working age) used to illustrate house index (blue) and oil price (red) relationship between each other and relationship to recessions.
Carry Trade Finance
Carry trade finance conducted by the Federal Reserve, a type of positive carry, has become more pronounced over the past 20 years.  Positive carry occurs when a bank's cash inflows can pay its cash out flows - when the the interest earned on investment loans can pay the interest on savings accounts.  When a bank cannot pay interest earned on accounts with interest earned through investment loans (as happened with the S&L industry at various times in the 1970s and 1980s) a bank is said to have negative carry, and is therefore technically insolvent.

Overview of carry trade finance - contraction and expansion of the spread between short-term and long-term interest rates coinciding with recessions. The current spread due to the late-2000s recession has been quite large and lasted longer than the previous cases.

To address any credit impairment as a result of a recession, the Federal Reserve conducts a policy of increasing, or expanding, the spread between short-term and long-term interest rates.  They do this by changing their target interest rate - the Fed Funds rate.  This encourages the sudden increase in government debt (normally acquired in recessions) to be passed on to short-term treasuries.  The accrued interest can be passed on to long-term treasuries.

Mid-1970s recession showing S&P500/Oil divisor and interest rates. Shortly before and during the recession, the 1-year treasury (purple) was paying higher interest than longer-term treasuries, but was not so after the recession.

Early-1980s recession, just as in the mid-1970s recession, 1-year treasury was paying more than the longer-term treasuries before and during the recession. Afterwards, the 1-year was paying less interest until shortly before the recession starting in 1990.  Oil prices were not affected by interest rates.

The modern era recessions in which carry trade finance became more obvious. Also, the relationship between interest rates and the stock market became closer.

In 1995, the stock market took off just as interest rates peaked. 1994 marked the CMO (collateralized-mortgage obligation) bond market collapse, due to the higher interest rates - an inverse relationship? As new government debt issues began to shrink (government surpluses) money was driven into the stock market, and conversely money was driven out of the stock market and into hard assets like real-estate.

Some correlation between interest rates and oil prices prior to the early-2000s recession and since then. Oil price is monthly WTI (West Texas Intermediate).
Recessionary Policy and Oil
While oil prices do seem to affect recessions, and affect government and Federal Reserve policy as a result; oil prices do not appear affected by most recessions or any government policy.  Stock markets started to show some corollary trends with interest rates starting in the 1990s.  However, not until after the most recent recession have oil prices shown their now tight (inelastic) relationship in which index/price movements follow a similar range.

Answering the Question So Far
Why is their now a tight, inelastic relationship with oil and stock markets?  The most recent recession was marked by a freeze in the credit markets.  Wary investors are now reluctant to make dedicated long-term bets like they were prior to the recession.  Cash has been stockpiled in bank accounts either worried about volatility in the credit market or waiting for rates to go up (likely to happen in 2015) or for a market boom to happen.

While my modified housing price index does not show a clear trend amongst oil and housing markets, when I combine data from British Petroleum's 2012 Statistical Review and Robert Shiller's housing market index (from the 2nd edition of his book Irrational Exuberance), there appears to be some kind of a recent 30-year trend.  I don't think it is of much relevance except for the relationship between the most recent housing boom and increase in oil prices.

I indexed oil prices in 2011 dollars from BP's 2012 Statistical Review and graphed in Robert Shiller's housing market index graph (from Irrational Exuberance 2nd edition).

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