When higher oil prices will start to hurt stocks

At first, the lockstep synchrony of the stock market and oil prices seemed counterintuitive. Then it became worrisome, as crude oil plunged below $30 a barrel last month and dragged U.S. stocks to new lows.

And in the past few weeks, with the correlation accepted as a given, the furious rebound in oil has helped the S&P 500 surge by some 10 percent in less than three weeks.

But as more investors warm to the prospect that oil has left behind a durable bottom, a new question arises: At what oil price would the rally in crude prices turn from positive to negative for stocks? After all, they say that as soon as one finds the key to the markets, they change the locks.

Traders work on the floor of the New York Stock Exchange.
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Traders work on the floor of the New York Stock Exchange.

Whatever that crucial price might be, we seem not to have reached it. For now, rising oil prices still set off a salutary chain reaction: Higher prices mean fewer debt-burdened energy companies are in peril, fortifying the market for risky corporate bonds and lifting equities with them.

Rising crude values also ease global deflation fears, and often coincide with broader commodity rallies and declines in the U.S. dollar, which together help emerging markets. And, finally, when oil manages to climb further off its lows, it offsets worry over whether prior weakness was due to flagging demand and growing risk of recession.

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This helpful feedback loop will likely persist, unless and until oil climbs high enough to stoke inflation expectations and feed a perception that the Federal Reserve will become more aggressive in raising short-term interest rates this year, even as more expensive energy products would begin a repeal of the "gasoline tax cut" enjoyed by consumers over the past year.

While it's impossible to settle on what this threshold oil price might be, a further rally into the $40 to $45 range per barrel of West Texas Intermediate crude would begin to place these concerns firmly in play.

Peter Boockvar, chief market analyst of the Lindsey Group, points out that crude oil averaged $48 a barrel in March 2015. So at "anything above $40," oil's drag on the consumer price index — already diminishing rapidly in recent months — would nearly be gone. He adds that gasoline futures, around $1.38 a gallon, are close to the six-month average price of $1.47, so this likewise will stop pressuring official inflation numbers with any further price increases.

Jim Paulsen, chief investment strategist at Wells Capital Management, figures that a run to around $45 would turn the rally from a welcome sign that the economy was firm, to a potential "problem for inflation." He points out that oil spent a good deal of time in this area late last summer, so a return there would begin to push headline inflation "back above where core [inflation] is now." In the latest core reading on personal consumption expenditures (the Fed's preferred gauge) was up 1.8 percent year over year, and core CPI gained 2.2 percent.

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If headline inflation were to break decisively above 2 percent, it could tilt the Fed-watching debate toward those who believe Chair Janet Yellen is inclined to try for a couple more rate increases this year.

Goldman Sachs economist Jan Hatzius has been in this camp for some time, calling the investor consensus "complacent" about the possibility of repeated rate hikes in coming months. He's been pointing out that the labor market continues to tighten and financial conditions have firmed up smartly. He also says that various measures of inflation expectations are artificially quiescent largely due to low energy prices.

His Goldman colleague Zach Pandl has tracked a tight connection between retail gasoline prices and various measures of inflation expectations, including the University of Michigan survey. Market-based indicators of future inflation embedded in bond prices likewise are quite sensitive to the action in crude futures, even on a minute-to-minute basis.

Of course, all of this could be moot if this vicious rally in oil prices proves a fleeting matter of short covering and unrealized hopes for supply cuts. There is already evidence that producers have taken advantage of the lift in more distant futures prices to sell production forward. This, in turn, lessens their need to cut production and could undermine the rally if supply stays high.

And, conceivably, the stock market could ultimately make its peace with a more resolute Fed that proceeds on its hoped-for path of policy "normalization" if it happens for the right reasons of sturdy U.S. growth and calmer credit conditions.

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Yet as things stand, traders seem unusually dependent on the oil-stocks correlation, so anything that disturbs the familiar interplay would invite at least a period of market unrest, given the broader environment of skittishness and loosely held investor convictions.