5 Ways Current Crude Oil Prices Should Deter Coming Fed Rate Hikes

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Includes: GOVT, OIL, PLW, SPY, USO
by: Foundational Research

Summary

It will cause crises and downward pressure on currencies in crude oil exporters, such as Russia. That, in turn, would sustain upward pressure on the dollar.

Lower crude oil prices could further mute the already-weak response of wage demands to falling unemployment.

The crude oil plunge could cast a shadow over the fastest-growing component of US capital spending - shale energy.

The Federal Reserve continues to pay too much attention to domestic trends and not enough to global trends. Most recently, Federal Reserve officials have played up the positive side of lower crude oil prices, while downplaying the risks associated with it. They continue to talk about mid-2015 rate hikes and the strong November non-farm payrolls report guarantees that the FOMC will not lower the interest rate "dots" at their December meeting.

The United States economy is "just fine" so the Federal Reserve could raise rates next year. But we would expect that to flatten the yield curve, accelerate the dollar rally and knock down equities. More likely, the Federal Reserve rhetoric will soften and the interest rate "dots" will move lower as 2015 progresses. This would be in line with our baseline scenario, which favors risk assets and yield plays.

One takeaway for strategy is that the bond market and dollar will continue to play an economic shock absorber role. The bond market helps sustain U.S. spending, while the strong dollar helps the rest of the world grow. The year-long divergence between 10-year Treasury yields and "Months to the First Hike," though completely at odds with the previous four years, may have further to run if the Federal Reserve sticks with its mid-2015 rate hike stance.

Also helping U.S. Treasuries is the low level of yields elsewhere. A 2.25% 10-year yield may seem low to U.S. investors, but German and Japanese 10-year yields are much lower, even Spanish and Italian yields are below comparable U.S. Treasuries. Buoyant job creation will sustain Federal Reserve talk of a mid-2015 rate hike, but we doubt it will happen.

Recent comments by Federal Reserve officials about what lower crude oil prices mean for the U.S. economy and inflation have been polarizing. Their overall broad message is that the "crude oil dividend" will boost domestic spending, that the central bank will "see through" the temporary drop in headline inflation, and that the crude oil plunge will not impact rate hike plans.

We respectfully disagree. There are five ways that the crude oil plunge helps delay the Federal Reserve rate hikes beyond 2015.

1) It will cause crises and downward pressure on currencies in crude oil exporters, such as Russia. That, in turn, would sustain upward pressure on the dollar and tighten U.S. monetary conditions.

2) U.S. long-term inflation expectations already were in the process of falling to five-year lows, even before crude oil accelerated downward. This holds for inflation expectations inferred from the bond market, as well as in the University of Michigan survey.

3) Lower crude oil prices could further mute the already-weak response of wage demands to falling unemployment. The November non-farm payrolls report reinforced the recent pattern of steady job creation and better employment conditions and wage growth only slowly recovering. At a minimum, it will take time to eat into the post-2008 labor market overhang, shown by the gap between the official unemployment and the broader U-6 rate, which tracks wage and salary growth. All of this was true before the OPEC decision to "let the crude oil market equilibrate on its own." Going forward, lower energy costs also reduce upward pressure on the cost of living, which could impact wage demands.

4) The crude oil plunge could cast a shadow over the fastest-growing component of United States capital spending - shale energy. This comes at a time when overall capital spending already has been underperforming many economist models.

5) Substantially-lower crude oil prices could impact Federal Reserve policy by reducing core PCE inflation. Headline inflation includes food and energy, while core does not. Nevertheless, there are indirect impacts. There has been a tight relationship between core inflation and crude oil prices over the long term.

More generally, the combined impact of a rising dollar and falling crude oil prices argues against rate hikes next year. The two trends reinforce each other in pushing down inflation, but macro models suggest that the real GDP impact of the dollar rise (negative) roughly offsets that of the crude oil drop (positive).

The crude oil plunge increases the odds that the Federal Reserve will not hike rates next year, although it could take time for the central bank to reach that conclusion. Good news for high yield portfolios, high-yield corporate bonds and defensive equity sectors.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.