“Never let a good crisis go to waste.” It’s as true today as when Churchill said it in the darkest days of WWII.
As soaring oil and gas prices pushed inflation to 40-yr highs in late 2021, it became obvious that the Fed would have to raise interest rates unless something rather unexpected happened. As we wrote on Jan 6 in One Way or Another:
There are lots of reasons for interest rates to decline. Inflation expectations could fall. Economic growth could slow. A central bank could pump trillions of dollars into buying up debt. They’re all effective, but they all take time and involve nasty consequences.
When it comes to a rapid response, nothing can hold a candle to an equity correction – the scarier the better – that sends equity investors running for the fixed-income hills. We saw this occur at the end of 2018 and in early 2020 – the scene of 21% and 35% corrections respectively.
That leaves us with the interesting prospect of a market correction that’s scary enough to bring rates down off the ledge, but not so scary that any real damage is done. The current taper schedule means QE will end in March. So, there’s plenty of time to to put such a plan into place before the Fed would be expected to start raising rates significantly.
Months ago, it seemed that oil prices might level off or drop slightly, offsetting rising prices in other inflation categories. The resulting decline in CPI might have obviated the need for multiple inflation-fighting rate hikes. But, even as the YoY increases in gas prices leveled off, CPI continued to spiral higher.The Fed had committed a grievous policy mistake. In their zeal to protect the stock market from even minor dips, they waited much too long to act. Sticky, intractable inflation had taken root in almost every corner of the economy, exacerbated by the Fed’s trillions. Even stalwart Fed fans began to admit that a strong response was necessary.
The 2Y climbed from 0.6% on Dec 3 to 1.6% on Feb 10. The 10Y climbed from 1.34% to 2.06%, well above levels seen just prior to the 2020 crash.In so doing, the 10Y completed a large Inverted Head & Shoulders pattern targeting 3.2%.Given the US’ $30 trillion in debt, these levels would be problematic enough from a fiscal standpoint. But, they would also result in the 10Y yields breaking out of a downtrend that dates back to the 90s. Could the breakout be contained? The last time the 10Y reached the top of the falling yellow channel (3.25%) was on October 5, 2018, when CPI had neared 3% following crude’s tripling over the previous 2 1/2 years. The only thing which was able to stave off a breakout at that time was a sudden and sharp downturn in oil prices.
WTI peaked on October 3, the day after journalist and Saudi dissident Jamal Khashoggi was assassinated and dismembered in the Saudi consultate in Instanbul at the direction of President Trump defended MBS from the ensuing fallout in exchange for an agreement to lower oil prices immediately and purchase $8 billion in arms from the US. He tacitly acknowledged this agreement one month later…
“If you look at oil prices they’ve come down very substantially over the last couple of months,” Trump said. “That’s because of me. Because you have a monopoly called OPEC, and I don’t like that monopoly.”
…and explicitly in a 2020 interview with journalist and author Bob Woodward.
“I saved his ass. I was able to get Congress to leave him alone. I was able to get them to stop.”
Given the apparent shortage of journalists willing to volunteer for the cause, we have no leverage over the Saudis at this time. WTI has risen from below zero in April 2020 to over 112 this morning. While some of that rise is a result of Russia’s unprovoked invasion of Ukraine, prices had already reached 85 before Nov 10, 2021 when suspicious troop movements near the border were first reported.
As Russia intensifies its efforts to take Ukraine by force, a decline in oil prices in the near future seems unlikely. Oil and gas prices have actually accelerated to the upside since the invasion began. However, yields have actually broken down.
Though we’re still in the early innings, Putin’s actions have indeed spooked markets, sending “equity investors running for the fixed-income hills” and giving the Fed the gift of lower interest rates without having to actually do anything to combat inflation.
The breakdown is minor so far. Such patterns typically result in a backtest of the trend line (known as the neckline) which marked their completion – currently about 1.63%. But, the longer it takes, the lower the backtest would be. A drop below the neckline would be significant and open the door to much lower rates.
There’s obviously no free lunch. Absent a sharp decline in energy prices, inflation is likely to be with us for a long time. It’s a tax on people without multi-million dollar portfolios – but only on those who eat, move about, wear clothes, or don’t live in a cave. Despite what Jay Powell might say in today’s Congressional hearings, the Fed’s dithering over the past year is a clear indication of their priorities.