Inflation suggests the oil bears are dreaming

“Reality is wrong. Dreams are for real.” – Tupac Shakur

Not a day goes by where oil isn’t mentioned in financial media given one of the most stunning and persistent collapses in history. With every downtick, some pundit comes on air arguing that $20 is the next stop. Of course, on any kind of an uptick from the day before someone will boldly call for the return to $60, but never mind the whims of prognosticators based on small samples and recency bias.

We all know there is both an oversupply and underdemand problem when it comes to black gold. There is no new narrative here. To some extent, we should all be hoping for lower energy costs, but only to the extent that those lower energy costs aren’t due to some severe drop in its usage.

With extreme bearishness in the commodity now, is it conceivable that the crowd is ultimately wrong because of something else the crowd may be starting to bet on?

Confused? First, take a look below at the price ratio of the iShares Barclays TIPS Bond Fund ETF TIP, -0.29% relative to the iShares Barclays 3-7 Year Treasury Bond ETF IEI, -0.24% As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEI. A rising ratio means the market is beginning to favor inflation protection, while a falling ratio indicates inflation expectations are falling.

Note that despite extreme volatility and ongoing chatter about oil USO, +2.58% breaking down for another leg lower, inflation expectations are holding.
This could be a very important divergence. If oil potentially falls further, but inflation expectations continue to hold, then it appears there may be a level of cognitive dissonance among the crowd given just how important oil prices are from the standpoint of cost-push inflationary pressure.

Of course, that is not to say that inflation expectations couldn’t fall out of bed and a deflationary wave couldn’t grip investor psyche at the very start of 2016. The current defensive signal our Beta Rotation Index (click here to view) is currently giving does suggest near-term risks are elevated for all risk assets. However, the contrarian inside me is starting to think the end of the decline may be near as reflation hopes, massively oversold, attempts to make a comeback.

For oil bears? That means the near-term risk is for a face-ripper of a rally some time in the first quarter.