Oil Price, Bond Return, and Breakeven Inflation

Compared with stocks, bonds are more directly affected by fluctuations in oil prices through the expected inflation component in nominal bond yields. Surprisingly, prior literature finds little predictive power of oil price changes on bond excess returns. This finding is counter intuitive, especially given the strong predictive relationship between oil price changes and equity risk premium. Using oil supply, global demand, and oil-specific demand shocks, estimated from a structural VAR model of oil price changes, this paper provides new empirical evidence - the oil price changes driven by global demand shocks predict negative real bond risk premium and positive inflation risk premium. Since these two effects offset each other, we observe insignificant effect on the bond risk premium. A two-sector New Keynesian model shows theoretically that real bond yield, breakeven inflation, and nominal bond yield respond differently to oil supply and demand shocks