Market View – The Federal Reserve and the rise in inflation risk
The dominant theme of 2018 has been a rise in the bellwether ten-year US Treasury note yield from 2.40% to 3% amid fears on Wall Street that a rise in wage inflation and Trump tax cuts will force the Federal Reserve into an aggressive monetary tightening. However, the Fed’s projection for the US economy and its preferred inflation measure (personal consumption expenditure or PCE) will be undermined by the dramatic surge in Brent crude, which could well propel the PCE to 2.5% by late summer. This is the reason I believe a June FOMC rate hike is almost certain.
It is ironic that the Russian-Saudi-OPEC oil output cut deal and geopolitical risks in the Middle East contributed to the surge in black gold, not necessarily above trend demand. Yet incoming Fed Chairman Jay Powell could make a policy error if his FOMC conclaves use the crude oil bull market as a reason to prematurely tighten monetary policy. Yet the rise in inflation break even rates and global metal prices (30% rise in aluminium after Rusal’s US sanctions hit!) definitely exhibit an uptick in inflation risk. The correlations between crude oil and inflation expectations are high at almost 0.5. The “prices paid” components of the purchasing manager manufacturing indices are also creeping higher. Inflation is creeping into factories, thanks to inputs like commodities prices.
Core inflation will continue to accelerate this summer and autumn, a disaster for owners of bonds, property or other fixed return assets financed by leverage. Unlike 2016-17, inflation risk is no longer skewed to the downside and the world’s central bankers will be forced to rethink their post Lehman money printing spree.
The history of the Federal Reserve since the late 1990s has taught me that its modus operandi is to launch preemptive rate hike strikes against an uptick in consumer price pressures. So I expect even a modest rise in the PCE or the core CPI above targets will force the Powell Fed to accelerate its pace of rate hikes in 2018 and 2019. The rise in three month LIBOR (and thus borrowing costs for leveraged bond and real estate punters, let alone debt addicted governments and corporates) presages the rise in the Fed Funds rate. As inflation overshoots the Fed target levels, the FOMC statement will get more hawkish and the Fed Funds rate could easily rise 150 basis points from current levels before the Federal Reserve achieves a “neutral” level. This autumn, the world will about the abandonment of the Bernanke/Yellen gradualist stance on monetary policy the hard way.
The inflation overshoots I expect from the data this autumn will not be transitory, even if a 2.5% CPI is nothing like the inflation nightmare of the 1970s and early 1980s. It is important to remember that the US business cycle is at a late stage, with a 3.9% unemployment rate, an epic tax cut, trade tensions with China, rising twin deficits, an oil shock and rising political risk in Washington. There is a time for greed and there is a time for fear. This is definitely the time for fear.
There is now also a non-trivial risk that a series of aggressive Fed rate hikes to combat an inflation overshoot will tip the US economy into a recession. From Paul Volcker in the late 1970s to Alan Greenspan in the early 1990s and Ben Bernanke in 2004-6, successive Fed chairmen have demonstrated that the Federal Reserve will tolerate even a recession to combat inflation. In 1992, Alan Greenspan’s rate hikes even costed President George HW Bush, the victor of Desert Storm, a second term in the White House. This would have never happened in a Third World banana republic where the central bank governor does not enjoy political independence. The independence of the Powell Fed will be tested as soon as his aggressive rate hikes doom President Trump’s bid for reelection. That will be the point when Chairman Powell will become Jughead Jerome on the Presidential tweeter feed and the world financial markets will tank in horror. As American politics degenerates into a surreal reality TV show, a 2019 recession could set the stage for a Democratic victory in 2020.
The surge in oil prices after US withdrew from the Iran oil deal is bad news for inflation in emerging markets with large current account deficits and huge external debts. This has led to full blown currency crises in Argentina and Turkey. Will financial history repeat itself in 2018? Don’t fight the Fed!
Wall Street – Crude oil, supply shocks and geopolitical risks
President Trump’s decision to withdraw from the Iran nuclear deal and reimpose financial sanctions on Tehran will have a profound impact on the global oil market. Since Brent rose to $77 once Trump ignored the pleas of France’s President and Germany’s Chancellor and unilaterally broke an international agreement, the geopolitical risk premium in crude oil can only rise. Iran’s exports to Europe and even Japan/South Korea will collapse. This could mean the loss of 500,000 barrels of crude in the wet-barrel market. Iran and Israel could escalate their military confrontation in the skies above Syria and Lebanon. Iran will also resume its nuclear program, setting off a new arms race in the region. It is no surprise that hedge funds are long 1 billion barrels in oil futures, options and swaps. The oil market is already tight since Venezuela’s financial meltdown has meant the loss of 500,000 barrels. Libya, Nigeria and Angola are also producing below targets.
Saudi Arabia now faces a strategic dilemma. Even though it brokered the oil output cut deal with Russia that removed 1.8 million barrels a day (MBD) of crude oil from the global market, it does not want an oil spiral that could trigger an economic recession in the West. As America’s key ally in the Middle East, it could be forced to increase output (the kingdom’s spare capacity is almost 3MBD, especially since Trump tweeted that OPEC “artificially” raised the oil price, a situation “unacceptable” to Washington. The geopolitics of black gold will determine the price of Brent.
Geopolitical shocks have been a recurrent theme in the international oil market. President Nixon’s resupply of Israel in the October 1973 war in the Sinai/Golan Heights led to Saudi King Faisal’s “oil embargo” and a fourfold increase in oil prices. When the Shah of Iran lost his Peacock Throne in 1979, crude oil prices rose from $18 to $45 even though the Iranian oilfields were a mere 4% of global supply. In August 1990, Saddam Hussein’s invasion of Kuwait triggered an oil panic, global stock market crashes and recession in the US and Europe. I lived in New York in the early 1990’s and remember Trump’s hotel/casino junk bonds in default. Yet time changes. The world moves on. The unthinkable becomes the inevitable, as Trotsky once put it. Even in 2018, oil prices reflect complex global financial realities.
Crude oil markets become more sensitive to geopolitical risk when global inventories are tight, not when they are in a glut. In June 2014, Daesh terrorists vanquished two Iraqi Army divisions, seized Mosul and established a renegade “caliphate” in a third of Iraq, OPEC’s second largest producer after the kingdom. Still, Brent crude plunged from $115 in June 2014 to $28 in early 2016. Geopolitics did not matter during a global oil glut.
The Saudi-Russian output cut deal in Vienna in 2016 were a game changer in the oil market. Saudi Arabia reverted to its role of OPEC’s swing producer, a role it had abandoned in November 2014. Riyadh ignored its political differences with the Kremlin on Syria and Iran to remove 1.8 million barrels a day from the oil market. Sometime last summer, when Brent was $45, I began to realize that global inventories had begun to fall, thanks to supply outages in Libya, Venezuela, Iraqi Kurdistan and Nigeria at a time when petroleum demand in Asia surged, led by China, India, Japan and South Korea.
The West’s commercial inventories have now shrunk to 2.85 billion barrels. Saudi oil exports have fallen to 7 million barrels a day. Yet global oil demand has risen by almost 1.8 million barrels, thanks to the first synchronized global economic recovery since 2010. Greek sovereign debt crisis.