Is Bond Market Betting Rising Oil Prices Will Check Inflation?

After shrugging off the first signs of blatant protectionism, the markets have begun to focus on the battle between inflation and deflation. The good v. evil debate was reignited when BoE governor King suggested that reserve hoarding at banks was hindering QE. Moreover, he was concerned that if the banks do not lend then a deflationary spiral may take hold.

However, to date the data does not support his fears. The U.K. National Statistics office released several measures of CPI and on a monthly basis, August CPI was up 1.6% v. 1.8% previous. While below the traditional 2% target zone, the gauge is far from showing deflation.

King’s argument is based on the output gap, or the difference between what the economy is capable of producing and what it is producing. King, along with virtually every other central banker, believes that the slack in the economy will keep inflation rates low. We have long agreed with this view. The flaw in our collective thinking is that relying on past estimates of the potential for current economic production assumes the world economies are functioning normally.

The trillion dollar question is how much damage has the credit crisis done to the output of the global economy. A large part of global GDP is comprised of financial services, which of course has been severely hobbled. Additionally, financial services serve as the mechanism to distribute capital efficiently. Clearly a broken financial system will leave capital stranded and/or hoarded.

This hoarding is occurring across the globe, but most notably in the U.K. and in the U.S. Both King and Bernanke have suggested that the next step for monetary policy is to reduce the amount of excess reserves held at banks. The most popular way to accomplish this has been called the “Swedish Model.” Sadly this model is less exciting than the name implies.

In July, the Swedish Riksbank decided to charge banks 0.25% on excess reserves. The goal of the program was to get banks lending once again. Now this model is being contemplated on both sides of the pond . The question now shifts toward the inflationary impact of the Swedish model.

Governor King seems to believe that an inflation rate below 2% has deflationary implications and suggested that the BoE may indeed take action; on this news the Pound has been weak.

In a sublime bit of carefully planned serendipity, the U.S. PPI was reported after the U.K. inflation report. The report showed that higher energy costs contributed to higher producer prices. Energy costs climbed 8% and gasoline specifically surged 23%. The result of the increase in crude oil and gasoline was a significant jump in the cost of crude goods for further production. The rise in crude goods means inflation is in the U.S. pipeline.

Certainly Governor King is a well educated, astute central banker and must have access to crude oil prices. Therefore we can safely assume he is aware of rising oil prices. So why then is the Governor so concerned about deflation?

It is our hypothesis that rising oil prices will act as an automatic stabilizer for inflation. We can see evidence of this phenomenon in the retail sales report.

Click to enlarge:

As gasoline prices rise, sales at gas stations do not rise as much, implying higher gas prices cause consumers to cut back. It is this self regulating economic development that could keep inflation in check as producers will be unable to pass along price increases.

Rising oil prices will act as a brake on economic activity and it is this “brake” that the bond market could be anticipating.

Despite rising oil prices and the prospect of a robust economic recovery, bond prices have been rising, causing bond yields to fall.

Curiously, as oil prices have retreated over the last several days, bond prices have followed. The implication of this move is that, counter-intuitively, bond investors see rising oil prices as an economic drag.

Comments

[chap08:]

Sluggish growth in the US would be enough to produce decent growth in Asia. Asian growth will push up oil, meanwhile the dollar will continue to fall. High oil costs and a lower dollar will import inflation to the US. The result will be something like stagflation. But rather than stagnation, for this cycle to happen at all, there has to be some, sluggish growth. So let's call it slugflation.

Sep 16 06:54 AM

[markfl:]

This thesis seems peculiar. The last spike in oil slammed the economy and hit consumers in the wallet. The fact that energy is volatile doesn't mean people don't have to pay for it. Some at the Fed have argued that they can withdraw liquidity and control inflation by paying banks interest on reserves. This assumes almost perfect monetary policy. It is difficult to predict incipient inflation and adjust monetary policy quickly enough. If inflation did spike, the FOMC would have to control it in the face of a high unemployment environment.

The whole issue I see being left out of recurrent debates on this subject (and numerous SA articles) is the difficulty faced by the FOMC in trying to run the Volcker playbook. Does anyone have the will to wring inflation out of the economy when the jobless rate is 8%? Investors need to factor these things into their inflation outlooks. Unemployment may be among the things most easy to reasonably predict. Unless millions suddenly drop dead, we can anticipate labor force size and job creation. Virtually all of the forecasts are in harmony, and there is little chance of less than 8% before 2012, unless there is a "V." People speculate, but a "V" is not the central tendency of forecasts, it is conjecture.

Sep 16 08:24 AM

[Ferdinand E...:]

Interesting and useful analysis except for one point: this Swedish model thing.

I read a Swedish newspaper every morning, and I have never read anything about a Swedish model, In fact those ignoramuses who handle the economics in the Swedish government and Central Bank proabably can't spell model.

If you want a model, go to Switzerland. They know how to take care of business. They don't belong to the (parisitic) EU, don't send soldiers to Eye-rak or Afghanistan, and they have at least a modest interest in keeping their large cities in a civilized state, even though there are many immigrants in the country.

"Swedish Model". What will it be next? .

Sep 16 10:05 AM

[SmartMoneyJoe:]

With the consequence of huge deficits and out of control government spending, the real value of U.S. Treasury securities are the focus of increased attention. China wants their assets safe and if any question of U.S. credibility would ensue, the pressure to liquidate a portion of their U.S. assets in self-survival mode may seem a likely option.

If China and other nations refuse to buy U.S. debt, the only alternative is for the U.S. Treasury to purchase Treasury securities which would dramatically increase the money supply. To attract investors, interest rates would need to rise. As is the case, when the Fed starts buying Treasury bills habitually, inflation ensues. The Fed in the mid-2009 scenario has used much of the money to buy over $500 billion in mortgage backed securities.

In a normal economic environment, higher interest rates would be associated with the central bank as they try to cool off inflationary pressures associated with an expanding money supply. However, with less demand for Treasuries, higher interest rates to attract buyer demand is the only viable recourse. Yet higher interest would only push an already declining economy, deeper in the hole. Higher interest rates mean a greater burden on the populace resulting in more mortgage defaults and negative pressure on consumer debt.
---------------
Look after your pennies, and your pounds will look after themselves.
www.personalbudgetinve...

Sep 16 01:41 PM

[ETFdesk.com:]

I am playing this headline with (LQD USL DBO OIL SPY DIA QQQQ) because interesting theory : 'It is our hypothesis that rising oil prices will act as an automatic stabilizer for inflation. We can see evidence of this phenomenon in the retail sales report." Let's see if the Bond market and Oil Prices are in sync and indicating slower growth...

Track the author's call over time... www.etfdesk.com/headli...

Sep 16 02:19 PM

[Whitehawk:]

I would argue that we already have much larger inflation than the usual Fed metrics would suggest. The price of gold has not been mentioned here. The stock markets are on a tear despite being overbought (and overpriced) by the indicators.

Sep 16 02:27 PM

[Donald Ingram:]

It is exactly this consumer cut back that inflation is not a factor at the moment. With asset deflation ongoing, wages lowering, grocery chain stores in a price war, rents decreasing and unemployment still ongoing and expected to rise further, I would suggest that deflation is active and accelerating at this time in the economy.

Sep 16 03:37 PM

[TxTim:]

Smart Money Joe,

I tend to agree with your points. But I don't understand the point about the US Treas buying it's own securities???
Let me point out that it has taken 10+ years for China to accumulate $800+bln in US debt. The Fed will print and spend $1.75Trillion in this year alone. If that ain't the Fed buying habitually I don't know what would be. This will surely be inflationary in a Freidman sort of way. But curriously the bond market plugs along as though $ 1.75 trillion in new money printing is no big deal--as though QE doesn't matter. Paint me stupid but if I was a big institutional bond investor I'd want my inflation premium. Makes me think of the movie Officer and a Gentlemen...maybe "THEY GOT NO PLACE ELSE TO GO!!" or they're seeing something that we aren't.


On Sep 16 01:41 PM SmartMoneyJoe wrote:

> With the consequence of huge deficits and out of control government
> spending, the real value of U.S. Treasury securities are the focus
> of increased attention. China wants their assets safe and if any
> question of U.S. credibility would ensue, the pressure to liquidate
> a portion of their U.S. assets in self-survival mode may seem a likely
> option.
>
> If China and other nations refuse to buy U.S. debt, the only alternative
> is for the U.S. Treasury to purchase Treasury securities which would
> dramatically increase the money supply. To attract investors, interest
> rates would need to rise. As is the case, when the Fed starts buying
> Treasury bills habitually, inflation ensues. The Fed in the mid-2009
> scenario has used much of the money to buy over $500 billion in mortgage
> backed securities.
>
> In a normal economic environment, higher interest rates would be
> associated with the central bank as they try to cool off inflationary
> pressures associated with an expanding money supply. However, with
> less demand for Treasuries, higher interest rates to attract buyer
> demand is the only viable recourse. Yet higher interest would only
> push an already declining economy, deeper in the hole. Higher interest
> rates mean a greater burden on the populace resulting in more mortgage
> defaults and negative pressure on consumer debt.
> ---------------
> Look after your pennies, and your pounds will look after themselves.
>
> www.personalbudgetinve...

Sep 16 03:56 PM

[jswede:]

a more uninformed post I've not read all week


On Sep 16 10:05 AM Ferdinand E. Banks wrote:

> Interesting and useful analysis except for one point: this Swedish
> model thing.
>
> I read a Swedish newspaper every morning, and I have never read anything
> about a Swedish model, In fact those ignoramuses who handle the economics
> in the Swedish government and Central Bank proabably can't spell
> model.
>
> If you want a model, go to Switzerland. They know how to take care
> of business. They don't belong to the (parisitic) EU, don't send
> soldiers to Eye-rak or Afghanistan, and they have at least a modest
> interest in keeping their large cities in a civilized state, even
> though there are many immigrants in the country.
>
> "Swedish Model". What will it be next? .

Sep 16 04:26 PM

[Thomas J. G...:]

I think this article is missing one of the most fundamental arguments about inflation. Inflation is a rise in the overall price level. When one price goes up for exogenous reasons, that is not inflation. Plus the entire conclusion is tenuous. The bond market is being influenced by gasoline prices? There are 1000's of things that can effect the bond market. I usually respect the editors picks, but this one is bizzare.

Sep 17 12:10 PM

[djackson:]

You write:
"As gasoline prices rise, sales at gas stations do not rise as much, implying higher gas prices cause consumers to cut back. It is this self regulating economic development that could keep inflation in check as producers will be unable to pass along price increases."

Two things. First, the logic does not appear airtight. Sales are the product of price times quantity. So while sales may not rise parallel because consumers reduce quantity, it says little about the ability to raise prices of gas. Your next step then tries to equate this to producers, I am assuming OPEC and the like given you do not identify, can't pass along price increase. Again, a kernel of truth, but BEGS the question of how prices got to $140 a barrel last year.

Second, the deflation concern probably centers more around minor things like the median US income adjusted for inflation being back at 1997 levels (see recent Census data), credit unavailability (see various Fed statistics), and the massive loss of consumer wealth which had been stored in their homes.

While under certain circumstances oil prices can correlate with bond prices, trying to equate a few days of recent movements is a major stretch.

Sep 17 03:07 PM

[punk_ash:]

probably its just the traders shifting money between fixed income and equities.

Oct 14 05:12 AM