Oil and Inflation Expectations: $85 oil is the threshold for regime shift
And a hedging idea
The 5-year inflation swap 5 years forward shows a clear bi-variate distribution during the past five years:
This corresponds to the relationship of the oil price to inflation expectations:
It is clear from the scatter graph that the relationship between oil prices and long-term inflation expectations is not linear, but rather divides neatly into two regimes (the scatter graphs of oil vs. 5-year and 10-year B/E’s look very similar). The low oil regime is characterized by low inflation not only because of the direct impact of energy prices on CPI but also because a large shift in oil prices affects the overall pricing structure as well as demand (especially because roughly a third of all S&P 500 CapEx was devoted to energy in 2014).
This suggests that an oil price in the mid-80’s would denote a prospective shift to a higher inflation regime. That would likely motivate more aggressive Fed tightening and represent a drag on economic growth.
This analysis suggests that deep out of the money oil options (perhaps warrants on oil producers?) would offer a good hedge against falling bond and equity prices.