Market Extra: Why an ‘oil shock’ sent the Dow down 2,000 points and upended global financial markets

Oil prices plunged Monday as Saudi Arabia and Russia prepared for a global price war, triggering a world-wide equity rout that saw the Dow Jones Industrial Average drop more than 2,000 points at its low, as shock waves traveled through financial markets already shaken by the spread of the coronavirus.

While falling crude prices, which mean lower gasoline prices for consumers, sound like they could be a balm during a period of economic stress, analysts and investors said the combination of sharply declining oil prices combined with existing fears over the economic implications of the coronavirus only heightened uncertainty and fear.

“The coronavirus presents investors with an unprecedented global problem. Investors are uncertain about the nature of the virus, its potential economic impact and the policy response. The oil shock has only added to this confusion and uncertainty,” said Paul O’Connor, head of the multiasset team at Janus Henderson Investors, in a note.

“One thing we do know, however, is that markets are now in panic mode,” he said.

Read:OPEC price war one of the three worst things that could hit virus-wracked markets: JPMorgan

Here’s a deeper look at what’s happening and some of the ways the crude-price fall is rippling through the financial system.

What happened to oil?

Oil futures fell more than 30% in early action late Sunday and the U.S. benchmark, April West Texas Intermediate crude
CL.1,
-24.51%

remained down 24.6% at $31.11 a barrel and May Brent
BRNK20,
+0.87%
,
the global benchmark, was off 22.2% at $35.23 a barrel. Both grades traded at their lowest levels since early 2016 and remained on track for their biggest one-day drops since the 1991 Gulf War.

Read:Investors brace for a race to the bottom, as an all-out oil price war erupts between Saudi Arabia and Russia

Why is falling oil a problem for stocks?

U.S. stocks plunged at the opening bell with trading briefly halted as a 7% intraday slide for the S&P
SPX,
-6.45%

triggered a so-called circuit breaker. Stocks remained sharply lower, with the Dow Jones Industrial Average
DJIA,
-6.56%

more than 1,950 points, or 7.7%. The S&P 500 was off 7.4%. Another circuit breaker would halt trade if the S&P 500 extends its daily loss to 13%.

See: Stocks will enter a bear market if the Dow and S&P 500 close below these levels

Oil accounts for more than 3% of the S&P 500, and banks are also exposed to the sector via loans. Meanwhile, pressure on yields tied to the collapse in oil prices is also bad news for financial stocks, analysts said.

The breakdown in oil prices also adds to fears of a global recession. And, with the U.S. now a net exporter and the world’s largest oil producer, falls in price, while offering some benefit to consumers, aren’t an unalloyed positive and may even be a net drag, economists have argued.

“Markets are trying to force a policy response — from central banks and from Washington, D.C. A basket of more aggressive monetary-policy action is coming, and how markets respond is the big question. The market will get something resembling ‘zero bound’ very soon, but that is not likely to be effective,” said David Bahnsen, chief investment officer at the Bahnsen Group, in a note.

Falling yields about more than a flight to safety

Investors flooded into havens, including government debt, sending the yield on the 10-year Treasury note
TMUBMUSD10Y,
0.546%

to an all-time low, last down 20.6 basis points at 0.507%, as the entire U.S. yield curve traded below 1%.

But the drop in yields, which move in the opposite direction of price, isn’t just about the flight to safety. The plunge in oil prices also takes the wind out of inflation expectations, adding to pressure on yields.

“The knock-on effects will slash inflation outlooks globally — the U.S. 5-year/year forward break-even rate is now plumbing the subdued inflation levels at the height of the 2008 financial crisis,” said Charles Hepworth, investment director at GAM Investments, in a note, referring to a market measure of expectations for future inflation.

Bad news for corporate debt, emerging market bonds

In addition to being bad news for energy stocks, pressure on oil prices promises pain on the credit front for leveraged companies. That adds to stresses in corporate debt that were already being amplified by the coronavirus outbreak, analysts said.

Check out:Cracks are forming in corporate bonds as coronavirus slams Wall Street

Nicholas Colas, co-founder of DataTrek Research, on Monday noted that energy has a much higher weighting in high-yield indexes used by exchange-traded funds like iShares iBoxx $ High Yield Corporate Bond ETF
HYG,
-4.52%

(10.3%) and the SPDR Bloomberg Barclays High Yield Bond ETF
JNK,
-4.84%

(11.1%) than the S&P 500 at 3.4% and the Russell 2000
RUT,
-8.82%

at 2.1%.

The HYG fund was down 4.5% on Monday, while the JNK ETF fell 4.7%.

Oil-exporting emerging-market countries also faced stress, putting pressure on their government bonds.

“The oil shock has jolted the hitherto-resilient markets for high-yield debt and emerging-market bonds,” said O’Connor. “The risk now is that investor redemptions will accelerate at a time when market liquidity is already under pressure.”

He argued, however, that the scale of the repricing was so rapid today that some value was beginning to emerge.

The iShares JPMorgan USD Emerging Market Bond ETF
EMB,
-7.01%

was off more than 4.7%, while the Van Eck Vectors JPMorgan EM Local Currency Bond ETF
EMLC,
-4.94%

was down 4%.

Dollar, commodity currencies sink

The U.S. dollar wasn’t acting much like a haven, with the ICE U.S. Dollar Index
DXY,
-0.96%

down 1% at 94.979. The Japanese yen
USDJPY,
-2.75%
,
meanwhile, asserted its role as a traditional safety play. The U.S. currency was down 3% versus the yen to trade at ¥102.09, the strongest level for the Japanese unit since September 2016.

Currencies of oil-exporting countries were set to see weakness.

“Oil is a significant driver of GDP in Mexico Norway, Canada, Russia, Brazil and Colombia, and, of course, the U.S. is the world’s biggest oil producer in absolute terms now,” said Kit Juckes, global macro strategist at Société Générale, in a note.

“None of those countries’ currencies is going to have a good day though the dollar does still derive support from its reserve-currency status,” he said.

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