Crude Awakening: Oil Prices and Bond Returns

Oil price changes fail to predict asset returns because they are too noisy. We construct an oil trend factor that fi lters out noise and provide evidence that it predicts bond risk premiums well. This result holds in developed and emerging markets, both in sample and out of sample. Notably, the oil trend factor improves predictions based on current term structure predictors, such as the first three principal components of yields and the Cochrane and Piazzesi (2005) factor. A puzzle emerging from our results is that oil price increases, which are generally thought to precede economic recessions, are in fact associated with subsequent lower bond returns. To solve this puzzle, 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 premiums, the oil trend factor is mainly related to demand shocks. Therefore, increases in the oil trend tend to signal a strong economy and lower bond returns.