Oil's epic plunge highlights US recession risk

Oil has tumbled 50% from its Jan. 6 peak

Crude oil is mired in a selloff of epic proportions, and its slide may hold some clues about what’s ahead for the U.S. economy.

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West Texas Intermediate crude, a benchmark for U.S. prices, plunged 24.6 percent to $31.13 a barrel on Monday after Saudi Arabia engaged Russia in a price war, at least temporarily ending the truce between the world’s second- and third-largest producers.

The sharp drop followed a 10 percent plunge on Friday, and extended the fall from a Jan. 6 peak of $62.69 a barrel to 50 percent. The median bear market in oil lasts 92 business days and entails a price decline of 34 percent. The swoon underway now has been just 46 business days so far.

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“The current sell-off is the most severe from-peak decline across all oil bear markets since records have been kept,” wrote Serena Tang, a New York-based strategist at Morgan Stanley.

Luckily, a bear market for oil isn't necessarily an indicator of a looming recession.

In fact, since 1983, Tang says only three of the 19 oil bear markets were precursors to a broader downturn. One troubling sign, however, is that the selloffs of 1999, 2000 and 2008 were all more severe than the median bear market, and all were followed by recessions.

While each oil bear market has its own unique story, the current backdrop is unlike any in recent history. In the U.S., the outbreak of the new coronavirus has so far caused only the cancellation of travel plans and social distancing.

Italy, however, instituted a nationwide lockdown on Tuesday that runs through April 3. The measures, which are the strictest outside of China, “boost the chances that governments elsewhere impose more draconian measures,” wrote Vicky Redwood, senior economic adviser at London-based Capital Economics.

The “damage to supply would be dwarfed by the hit to demand" if that happens, she said, increasing the drag on inflation.” That would pose trouble to a U.S. economy where the 5-year/5-year forward, a key indicator of inflation that measures the 5-year inflation rate starting five years from the present, is at its lowest level since the financial crisis.

Credit strategists at Bank of America say the “toxic combination of virus risk and a collapse in oil prices” caused the second sharpest single-day move in investment-grade U.S. spreads, trailing only Oct. 10, 2008, at the height of the financial crisis. On Monday, the spread between investment-grade corporate debt and safer government debt widened to 188 basis points, from 39 basis points.

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“In a non-financial crisis recession, we think IG credit spreads widen to about 250 bps,” wrote credit strategist Hans Mikkelson. “Hence, valuations here provide attractive cushion against recession risk, and we expect no recession in the first place.”