Oil price surges and the yield curve

Abstract

This thesis examines the effect of changes in oil prices on the term structure of interest rates. For this purpose, we consider The Organization of the Petroleum Exporting Countries (OPEC) announcements as the source of supply shocks since OPEC is the leading organization for oil supply in the world and has a significant influence on the market determination of oil prices (Känzig, 2021). We conduct an event study using oil supply shocks proxied by market based surprises as in Känzig (2021). Event study regressions show that oil supply news shocks significantly affect long term yields, while the effect does not exist in the short term in the United States (U.S.) context. We argue that these findings can be justified by the response of inflation risk premium where an increase in oil price increases the compensation for holding nominal bonds. We model this mechanism by using a simple consumption-based asset pricing setup. The model analytically shows that simultaneous, empirically supported, reverse direction movements in the consumption growth of goods other than oil and oil supply news shocks can increase the inflation risk premium and put upward pressure on yields.