Bearish On The Fed's Ability To Raise Rates? Implications For Oil

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Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, USOI, UWT, WTID, WTIU
by: Long/Short Investments
Summary

The Federal Reserve may raise rates up to around the 3% mark this business cycle, but I believe it would be a mistake.

The developed world is awash in too much debt and can’t effectively grow their worker bases.

This has implications for interest rates and financial assets, including oil.

I believe that due to structural forces in the world economy, the Federal Reserve will be unlikely to be able to raise rates up to 2.75-3.00% by year-end 2019. This has implications for oil (NYSEARCA:USO) (NYSEARCA:OIL) and other financial assets, but before getting into that, I'd like to address the macroeconomic situation to set the context.

Developed economies, particularly the US, EU, and Japan (~45% of all global economic activity), are sitting on large quantities of debt. As rates go up, debt servicing costs increase. This takes financial resources away from other economic initiatives and slows down the pace of economic growth. Thus, the higher the debt load, the more effective monetary tightening will be in slowing the pace of inflation.

If we look at MZM (money zero maturity) velocity, a form of money velocity which essentially mirrors a smoothed out inflation trend, we can observe that any monetary tightening in excess of the trend in this metric precedes a recession.

(Source: St. Louis Federal Reserve)

This doesn't work when looking at alternative forms of money velocity (e.g., M0, M1, M2) given the way in which they're calculated. MZM is unique in that it effectively measures the rate at which spending works to increase prices in the economy.

Money velocity is defined as how frequently one unit of currency is used to spend on goods and services within a certain period of time. However, the rate at which a certain amount of money makes its way around the economy (as a percentage of nominal GDP) isn't a very accurate portrayal of what money velocity is. Rather, money velocity is more accurately the rate of credit formation as it relates to nominal GDP.

Inflation itself is a proxy for the demand for credit. Credit expansion and debt servicing drive business cycles, and thereby the cyclical ebb and flow of inflation. As a consequence, inflation substitutes can provide insight into where equilibrium interest rates should be.

Over the past five years, the Fed has been steadily revising its forecast of the neutral rate from 4.25% down to its current 3.00%, and expects to hit around 2.75-3.00% by year-end 2019, with a long-run neutral rate of 3.00% (i.e., the rate at which the optimal balance between unemployment and inflation is achieved).

However, I think it will have a hard time getting there. The demand for credit remains low and has been trending lower (as suggested by the MZM velocity). Global indebtedness is high, which means monetary policy is going to be very effective at slowing economies down due to the above-mentioned financial resource diversion.

At the same time, aging demographics prevent developed economies from growing their worker bases fast enough. The prime age (25-54) population in the US has been virtually flat since Q1 2001 (top image below). Meanwhile, the 65+ population (bottom image) has been increasing exponentially since the mid-2000s.

(Source: St. Louis Federal Reserve)

The trend is even more slanted in the EU and Japan. This works to run up dependency ratios and contributes to higher budget deficits and higher debt loads. And this is a major drag on consumption, business investment, and the government's ability to contribute to economic activities. So while tightening in the short term can make sense to a slight degree, longer term the trend is still very much down.

Additionally, due to the zero/near-zero overnight rates in developed economies and ongoing/unwound quantitative easing stimulus, the capacity for easing to facilitate further demand is limited. QE is fundamentally about boosting financial asset prices to make people wealthier. However, as this is done, the forward spreads in returns between financial assets and cash have become compressed.

When bond yields are bid down to the returns on cash, and equity yields become closer to traditional bond yields - essentially risk premiums are being whittled away - there is decreasing incentive for investors to keep pushing themselves into riskier assets.

This points to asymmetric risk/reward and the likelihood that rates will remain lower for longer by necessity, in addition to bloated central bank balance sheets, and eventual calls for innovation regarding a third form of monetary policy. This could come in the form of directly monetizing budget deficits or placing hands directly in the hands of consumers (tied to spending incentives), but this is branching into a different topic altogether.

Relevance to oil

Monetary policy influences all asset prices. The Fed's policy decisions are especially important given its control over the world's largest economy (about 25% of all global economic activity) and the fact the dollar serves as the world's reserve currency.

If the Fed does come to the realization that it won't be able to hike rates to the 2.75-3.00% level this cycle as I expect (or at least I think doing so would be a mistake based on current information), this would provide a little more juice to both stocks and bonds, holding all else equal. Assuming any decision to hike less aggressively is not related to anything that would adversely affect corporate earnings, cash flows would be discounted at lower interest rates. So there is that.

Additionally, there is a link between interest rates and oil even as a non-cash producing asset. Lower interest rates - or lower interest rate expectations - tend to put pressure on the dollar, as lower yields on USD-denominated assets drive down its price. A lower dollar in turn tends to increase the price of oil and other commodities.

The relationship is displayed below (Federal funds rate and US dollar index are multiplied by four to make the relationship clearer):

(Source: St. Louis Federal Reserve)

The inverse correlation between the dollar and oil is well known. It is based on the fact that the US dollar is, as mentioned, the world's reserve currency and therefore the way most commodities are priced.

Of any foreign exchange asset, over a long enough period, the dollar has been the most stable. This incentivizes other countries to hold dollars as foreign exchange reserves. Consequently, when it comes to international trade arrangements for commodities and other raw materials, the dollar is the primary means of exchange.

When the price of the dollar falls, it takes more of the currency to buy oil or other commodities. This is beneficial for non-US buyers, which see their currencies appreciate relative to the USD. Dollar-denominated assets thereby become cheaper. Holding all else equal, this increases demand for oil and drives up its price.

Therefore, if the Fed does have issues following through on another eight rate hikes over the course of the next 2-1/2 years, this could benefit the oil market to an extent (The market has very much bought into the Fed's plans based on market-implied probabilities).

Oil is predominantly a supply and demand driven market. The supply side has been the main driver over the past few years. Any impact from Fed policy operates on the demand side.

Taking monthly data from 1975 to the present, the correlation between the dollar and oil is -0.362, with -1 being a perfectly negative correlation and +1 being a perfectly positive correlation.

Based on six different regression models that I use to model the price of oil, a 100bp drop in the Federal funds rate (relative to what's priced in) would increase its price by 1.8-3.3%. For those who own stocks in oil companies, how such an event could impact their prices would depend on the sensitivity of their earnings to the price of the underlying commodity. Companies with a greater concentration of their earnings dependent on the performance of their upstream operations will be more sensitive relative to those with more of their earnings concentrated in their downstream operations.

The price of oil has about a 40-60% correlation with the performance of stocks of upstream-heavy corporations. It is more closely around 0-30% for the stocks of downstream-heavy companies.

Rate hikes being priced out of the curve would also directly impact stock valuations, but it would be impossible to know how this would be transmitted in equity prices without knowing what caused the dovishness in the first place. If it's in response to factors that move financial markets directly - i.e., downward revised growth and inflation forecasts - then there could be little change. A hypothetical pricing out of 100 bps of tightening resulting in a parallel downward shift in the yield curve, with no other variables influenced, would drive equity markets up by about 30%.

Conclusion

The Fed is likely keep its foot on the gas in raising rates, but hiking up to around 3% by year-end 2019 I think would be a mistake and shows excess focus on short-term considerations (i.e., the current business cycle). Longer-term disinflationary forces exist in the form of too much global indebtedness, aging demographics, excess industrial capacity in parts of the Chinese and Indian economies, China's capital outflows (which pressure the yuan and work to appreciate other global currencies, which is inherently disinflationary), productive resource underutilization, and US domestic pricing headwinds in the auto and housing sectors.

While an overnight rate of 3% is largely priced into the curve already, any pricing out of this level of tightening could bode well for stocks, bonds, and commodities, though less so for the US dollar.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.