Crude Oil has been on the rise. Two months ago oil traded at $26/barrel and today it is above $41. Perhaps the 61 cent increase in gas prices doesn’t bother you but it certainly could be a threat to bond yields everywhere. Today the 10yr trades at 1.76% and identical to where it was two months ago; so where is the threat from oil? The answer lies in inflation, or more precisely inflation expectations. 10yr yields haven’t moved much given the movement in oil so it’s hard to point that there is a direct correlation. However, higher oil prices could, and likely will, increase inflation expectations. The FOMC has done a rather poor job on raising inflation and for the most part their forecasts for interest rates have been entirely wrong. Their stance has shifted to having an appetite for interest rate hikes but little urgency to do so. Certainly inflation has been the single largest reason they haven’t raised since December. But this is a Fed not to be messed with and a Fed to be taken seriously. They will not back down and instead have switched to the battle over inflation expectations. Inflation expectations often precede inflation and the inflation battle has moved to a battle over the minds, over belief, over the future. The Fed has planted the inflation expectation tree and now hopes it grows.
Despite oversupply and some serious headwinds in China, we’ve seen oil rise 58% in two months.Did we all miss some world changing, reality shifting event that never made it into a single newspaper? No, you didn’t. Oil is trading higher on hope of growth around the world and a reduced supply of shale (perhaps even a possible production output cut from large oil producing nations).
The Fed has to love the movement in oil. Feed the inflation expectation beast. This is a dangerous and desperate game the Fed is playing. The market moving with shifting expectations will be fast and furious. But can we really point the finger at the Fed as starting the inflation expectation ghost story? Not really, but they certainly didn’t get out of the way when the market was reaching for an answer to this new reality. That reality is the following: the Federal Reserve, the most powerful governing body in existence, really doesn’t have a single clue what is going to happen to the world’s largest economy or any economy for that matter. We are looking for answers to some of the most important questions we can face today and their response is ‘we will let you know when we figure it out but right now we have no idea’.
So keep your eyes on the market. If the inflation expectations angle fails, the 10yr could fall as far as 1.50%. There is even a scenario with rates dropping and inflation expectations going to zero that could put the 10yr at its lowest level all-time. But if it succeeds, and inflation does move closer to reality, the 10yr at 2.00% plus could be here in a heartbeat. Like I said, this is a dangerous and desperate game which reeks of volatility. For now the market is calm but with a fast rising oil market, sooner or later something will change materially. Oil could keep rising, it could fall back and possibly the 10yr holds here but the stage has been set for drama, let’s see if the show ever starts.
10yr yields around the world (US debt looks very attractive):
Fed Funds implied probability for rate increase this year:
June 15th 17.6%
July 27th 27.3%
September 21st 38.7%
November 2nd 41.3%
December 14th 51.5%