The dramatic rise in energy prices is ultimately deflationary

The Swiss had imposed negative rates on foreign currency deposits in the 1970s to counter the upward pressure on the franc, but Denmark became the first central bank to put its policy rate below zero in 2012.  There are now around $11.8 trillion of negative-yielding bonds, the least, incidentally, since mid-2020. At the end of 2019, the value of bonds with a negative yield was slightly below $11.3 trillion. Nevertheless, the meaning and implications of negative-yielding interest rates continue to vex even the most seasoned of market participants. 

An unusual confluence of factors saw oil prices in April 2020 drop below zero.  Even understanding the drivers, it is still mind-boggling. One ostensibly had to pay someone to take the crude oil away. And now, the opposite is just as unexpected. Oil prices, and energy prices, more broadly, have surged. As is often the case, it is over-determined, in the sense of many causes, including the volatility of weather where droughts have cut into hydroelectric generation (e.g., Brazil), and low winds have reduced this source of renewable energy (e.g., Northern Europe). The storms in the Gulf of Mexico took out production and refining capacity. Inventories in the large economies were low to begin. The jump in natural gas prices is leading to shifts back to oil, and estimates of this demand range from around 500k barrels a day to possibly as much 2mln barrels as the Northern Hemisphere works its way through the winter. 

OPEC+ has so far stuck to its plans to boost production by 400,000 barrels a month until entirely replacing the amount taken out in 2020. After many pundits had declared that OPEC was dead, the disciplined strategy underscores its role as the swing producer. How to restore credibility? Develop a plan, make a commitment, and deliver. If oil heads dramatically higher, and with the world clamoring for help, it can ride to the rescue, boost output and validate its gravitas. 

Where is the shale that had appeared to get the upper hand from OPEC?  It turns out that shale production does not only need geological formations, technological advances, a certain attitude toward nature, and access to a particular type of capital. The shale sector is not using its windfall from the higher than anticipated prices to expand capacity as it previously did. Instead, now it is returning capital to its investors.

The rise of oil and gas prices is not like other price increases. They are essential inputs to agriculture (especially fertilizers and pesticides), manufacturing, and transportation. On the one hand, this sounds like it is inflationary. Leaving aside the market turmoil in March 2020, the correlation between the change in the US 10-year breakeven (the difference between the conventional 10-year yield and the yield on the inflation-protected security, a handy real-time metric of inflation expectations) and the change in the price of WTI oil is near 0.6%, a five-year high.

On the other hand, given the widespread use of oil and gas, the dramatic increase in prices should be considered a tax on consumption. Imagine country A boosts the value-added tax sharply. The general price level rises, but a tax increase is not the stuff inflation is made. Quite the opposite. A dramatic VAT rise would initially lift consumer prices in our thought experiment, but it would weaken demand and ultimately be a deflationary impulse. In fact, discretionary spending typically gets hit hard when oil prices surge. Norway is one of the few central banks that publish an underlying CPI measure that excludes energy and adjusts for tax changes. It is not coincidental that the last three downturns in the US business cycle before the pandemic were preceded by a doubling of the price of oil. Over the past year, oil prices have more than doubled. 

In the face of surging energy prices, the US CPI has stabilized. It remains elevated, for sure, but the year-over-year pace has been steady at 5.3%-5.4% for four months through September, and the core rate, which peaked in June at 4.5%, now sits at 4%. The last annualized rate of CPI in Q3 was less than 5%. The annualized pace in Q3 was nearly 10%.

Japan, the UK, and Canada report September CPI figures in the week ahead.  Japan was still experiencing deflation in August. Indeed the headline measure has been below zero since last October. The core rate, which excludes only fresh food, rose to zero in August. It had been negative since August 2020. However, the rise was a function of energy. When fresh food and energy were removed from the basket, consumer prices were 0.5% less than a year ago. The continued surge in oil and gas prices and rising food prices, coupled with a weaker yen, may help Japan overcome deflation. It makes the Japanese government bonds look somewhat less attractive.

The 10-year yield is knocking on 10 bp, which it has not traded above since April.  The year's high was set in late February near 18 bp, just shy of the 20 bp, which previously BOJ Governor Kuroda clarified that the upper end of the range under the yield curve control regime. Equities may benefit from more price pressures. Still, there is uncertainty about the new prime minister's agenda, outside of a hefty (~JPY30 trillion, or ~$265 bln) of fiscal support in Q4, even if general election later this month.

When the BOE's chief economist Haldane stepped down over the summer, observers lamented he was the lone hawk. Hardly. In fact, several officials, including Governor Bailey, have fanned expectations that a rate hike will be delivered in December as the Gilt buying ends. Since the BOE's meeting on September 23, the implied yield of the December short-sterling futures contract (a three-month deposit rate) has risen by almost 25 bp to nearly 0.40%. The base rate stands at 10 bp.

That said, the rhetoric has spurred the market to prepare for a hike as early as the next BOE meeting on November 4. As a result, the implied yield of the November short-sterling futures contract has risen by about 13 bp since the last BOE meeting to imply a yield of about 22.5 bp.

The swaps market also has around 25 bp of tightening priced into the next three months and about 80 bp of tightening over the next year.  Fiscal policy is also expected to be less accommodative when Chancellor Sunak delivers the budget later this month. Among the G7 countries, the IMF has the UK's economy to be the smallest relative to its 2019 forecasts in 2024. The US, Canada, and Japan are forecast to be larger, while the big 4 in the EMU will be slightly below where the IMF project before the pandemic struck.

The BOE's preferred measure of inflation includes owner-occupied costs, and this measure CPIH was at 3% year-over-year in August, and ironically, the core rate was slightly higher at 3.1%.  While the IMF expects inflation to return to pre-pandemic levels by the middle of next year, it recognized differences between countries and identified the UK (and the US) with risks to the upside. 

Among G7 economies, after the US, Canada may have the highest inflation (it stood at 4.1% in August). However, Canada has three core measures (common, median, and trimmed), which are considerably lower. The average of the core measures was nearly 2.6% in August. Still, the Bank of Canada targets the headline CPI in a 1%-3% range. Governor Macklem insists that inflation is temporary, though the rhetoric appears to have turned a little more hawkish recently. 

For several months, the Bank of Canada has projected its output gap will close around the middle of next year. The market understood this to be the rough timing of the first hike. Since the September 10 Bank of Canada meeting, the implied yield of the June 2022 Banker Acceptance (three-month interest rate) futures has risen by about 37 bp through the middle of last week before consolidating. Over the next 12 months, the swaps market is pricing in about 75 bp of rate hikes.

There has been a dramatic increase in interest rate expectations in the US, Canada, and the UK. The US dollar's strength is well known. Since last month's Bank of Canada meeting, the Canadian dollar has wrestled the Norwegian krone, which hiked rates on September 23, for the top of the G10 currency performance table, up around 2% so far this month. In contrast, sterling has fallen by around 1.5%. It is not clear why sterling has underperformed.

Bonds have sold off more than in the US and Canada. The FTSE 100 has outperformed, but the FTSE 250 hasn't. The UK seems to be vulnerable to a policy mistake. Fiscal policy set to tighten, and the monetary lever will go from adding liquidity (QE) to none and a rate hike in short order. At the same time, the disruption of the UK's fragmented energy market is an additional hurdle. On top of that, the pandemic is not over. In the middle of last week, the UK reported its highest number of new cases in three months.

Lastly, while inflation seems to be a key focus, two other sets of data will attract interest. The first is the preliminary October PMI at the end of the week. Supply chain disruptions may weigh on the manufacturing survey, while the apparent cresting of the recent Delta wave may help make the services component more resilient. The second is China's Q3 GDP due at the start of the week. Between the Delta mutation, the flooding, and purposeful cuts in emission-intensive production warns that the world's second-largest economy likely slowed considerably. The quarter-over-quarter pace is expected (Bloomberg survey) to slow from 1.3% to 0.4%, which is the pace of the expansion in Q1 21. With low consumer inflation (0.7% year-over-year in September) and slowing economic activity, the PBOC has scope to ease policy. Most observers who expect it to act envision a follow-up cut in reserve requirements after a similar move three months ago.