Crude Awakening: Oil Prices and Bond Returns

Abstract

Oil price changes fail to predict asset returns because they are too noisy. We construct an oil trend factor that filters out noise and provide evidence that it predicts bond risk premia well. This result holds in developed and emerging countries, both in sample and out of sample. Notably, the oil trend factor improves predictions based on current term structure predictors, such as the first principal components of yields and the Cochrane and Piazzesi (2005) factor. Our results indicate that oil price increases are associated with subsequent higher bond returns. Besides, we demonstrate that not all oil price shocks are alike: Although oil demand and supply shocks have opposite implications for economic activity and bond risk premia, the oil trend factor is mainly related to demand shocks. Therefore, increases in the oil trend tend to signal a weak economy and higher bond returns.

Keywords: bond risk premium, demand shocks, oil prices, return predictability

JEL Classification: G11, G12, G15, P36