Oil will dominate the news this week as the market absorbs OPEC’s decision and economists try to figure out what it means for inflation expectations.
Higher PPI, Higher Yields
US Producer Price Index (PPI) blew out all expectations, rising 0.6% month-on-month and 2.9% year-on-year. The expected seasonal declines in gasoline prices were just not happening in October. Gasoline prices were up 0.8% in October. Increasing prices at the pump also translate into higher prices of feedstock for food production.
Final demand trade services, which are linked to the latest tariffs, were also a major contributor to Core PPI. It registered the largest monthly increase in four years, rising 1.6% as both wholesalers and retailers passed down the levies on Chinese goods onto their customers.
With PPI running so hot, it is was no surprise then to see little change in the Fed’s stance after last week’s FOMC meeting. Following September’s hike, the Fed continued to signal a December hike was still in play. The recent shakedown in equity markets did not materially alter its views, and the Fed continued to emphasize that its long-term inflation expectations are little changed. With the strengthening job market, the Fed is now fixated on inflation control as its primary mandate. We were right about previous rate hikes, and we continue to expect another hike in December.
In our note to clients on 17th of September, we wrote:
We expect to see the Fed Funds Rate rising in September, which will make the dollar funding trade more painful. An escalation of the trade war will not help because import price inflation will be felt more immediately than the effect of the drag on aggregate demand.
And that is exactly what happened. Final demand trade services surprised everyone, and PPI is leaving little room for the Fed to change its path towards higher interest rates. To repeat what we wrote on the 10th of September: with “the potential increase in import prices from the trade war, the Fed will be left with no choice but to raise rates.”
Our theme on rising yields has benefited from a key factor: the rising oil price. Energy prices are large contributors to PPI, and decelerating PPI is one reason for the Fed to stop hiking rates sooner rather than later. While it is still too early, a significantly lower oil price could offset inflationary pressures from the trade war and tight labor markets, and it may end up being the reason for the Fed to pause its increases of interest rates. This is especially true now as the United States surpassed Russia to become the largest crude oil producer, with shale oil becoming a material contributor to US GDP growth.
Recall that it was the last downturn in oil prices that triggered the economic soft patch in 2016, in which US exploration and production companies were forced to significantly reduce their workforce and capital expenditures. The reduction in investment impacted GDP growth, which more than halved by mid-2016 to 2.3%. Prompted by this slowdown, the Fed paused its interest rate hikes for one year until other sectors of the economy took the lead in growth.
Crude oil has been rallying on the back of lower supply due to OPEC quotas, the looming sanctions on Iran, and technical problems at major producers like Venezuela and Angola. The sudden turnaround coincided with Trump’s announcement of import exemptions for eight countries. The waivers will allow some Iranian oil exports to cap the price rises. In Trump’s own words: “I don’t want to drive oil prices to $100 a barrel.”
Oil Cartel Moves
OPEC and Russia met over the weekend and decided to cut supply. Details are pending, but we expect the voices in US Congress to get louder, with some already working on resurrecting the NOPEC bill that was supposed to amend the Sherman Anti-Trust Act to target OPEC. The proposed legislation makes it illegal for any international cooperation that limits the production of petroleum products.
The Sherman Anti-Trust was not meant to target the oil market’s regulatory mechanism for price stability. In fact, United States oil laws and regulations encouraged the regulation of oil prices to smooth out the effects of the boom-bust cycle, which were quite severe for the petroleum industry. It was the Texas Railroad Commission that first set out to control price fluctuations from the 1930s to the 1960s after the East Texas oil boom created a crisis that plunged oil prices to an unsustainable level. In the hands of the private sector, producers have trouble remaining solvent during the bust, and that threatens the uninterrupted supply of a strategic and economically important resource.
Today, we have a different environment. Shale production is relatively quick to ramp up compared to traditional wells, and the world is moving to electrify its transportation infrastructure and diversify its energy sources. There will be a time when the price stability that OPEC provides will no longer be necessary, and that time is closing in. Is it any surprise that the King Abdullah Petroleum Studies and Research Center in Riyadh was recently commissioned to study a world without OPEC?
Trump has made no secret of his dislike of OPEC, and he has threatened to break up the cartel. As always, the statements could be more of the same political posturing to squeeze better deals out of OPEC member states. Saudi contracts come to mind. As the Khashoggi story unwinds, some US corporates might find themselves at a disadvantage for skipping the Saudi economic summit, and that will be in Trump’s agenda to rectify.
Same Movie, Different Actors
The dispute between the Indian government and the Reserve Bank of India over monetary policy independence sounds familiar. It is a recurring theme in emerging market governments at odds with self-preservation and currency stability. Foreign currency denominated debt and a reversal of capital flows are the roots of the problem.
In India’s case, it’s the private sector borrowing in foreign currency. During the boom, the capital inflow of foreign currency creates bid up asset prices in a virtuous cycle. When the trend reverses, policymakers have a hard choice between a deflationary deleveraging process or an inflationary currency devaluation. In extreme cases, the devaluation can trigger a spiral of hyperinflation.
India is a unique case because of the relationship that the Indian government has with the banking system. There is a clear conflict of interest when the Indian government, a majority shareholder of private sector banks, invokes Section 7 of the Reserve Bank of India Act at a time when the Reserve Bank of India (RBI) is trying to clean up bad debt and tighten lending standards. Political interests are also miring the situation with Modi positioning for the general election during an economic slowdown.
India is stuck between a rock and a hard place. On the one hand, the RBI is trying to manage capital flight out of India’s markets. On the other hand, Modi’s government is responding to a slowing economy and positioning for elections. An unexpected gift from Trump had India included in a list of countries with exemptions from importing Iranian crude oil. While details are yet to be announced, the oil price correction and the recent reversal of capital outflows is just what India needs to get back up on its feet again. Crude oil imports represent the largest outflow of foreign currency out of India’s economy, and this will help correct its stubbornly high current account deficit.
The Week Ahead
Lots of activity in India this week as the central bank governor meets with parliament over monetary policy independence. GDP figures are expected out of the Eurozone. Media focus will be on Germany’s GDP, and the expected slowdown will lend support to other European political forces aiming to loosen fiscal policy rules for the entire block. Also of note are CPI figures coming out of the US and most of Europe. The UK’s CPI should be especially interesting because it is expected to come in above the Bank of England’s target, raising the prospect of a rate hike at a very bad time.
The US is closed on Monday for Veterans Day.
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