Monday, 2 February 2015

The double risks of an oil rally and the road to 1994.

One of the things I have been trying to get my head around is how the assumed association between inflation and growth has become so strong that many seem to believe that they are one. As a dog is likely to experience fleas finding a flea does not mean there is a dog attached to it. Growth is likely to experience inflation and recession experience deflation. But inflation does not lead to growth and deflation does not need to lead to recession. 

Oil and energy prices are the main cause of the deflation we are currently seeing but that in itself is stimulatory.  Central banks are responding to their deflation gauges by erring on the side of further stimulation. So rather than one countering the other we are seeing Dr.Aghi and his clan administering double the dose. Which is all very well and rather pleasant as long as any growth doesn’t see inflation, or rather any rapid inflation. 

Central banks respond to historic data and could be considered to be driving down the economic highway with their windscreens covered up using the rearview mirror and the instruments to navigate by. Which is fine as long as the curves in the road are gentle but fatal if sharp bends are ahead. My concern is that the stimulation due to deflation caused by stimulatory effects will heighten the chances of a sharp bend ahead. If energy prices were to rise suddenly we would have inflationary effects occurring just as CB policy has adjusted for the reverse. 

Which brings the risk down to a spike in oil. One just has to sum all the commentary and forecasts for oil prices to see that the bias is hugely to the down side which would suggest that the risk of an oil spike is all the more likely. 

Oh look. Oil is rallying hard and is up 12% in less than 24 trading hours. The news event this is being pinned on is friday's data of rig closures and the price move has so far been explained as short covering. Which to your author’s ears normally is a dismissive statement of hope and denial that prices could go higher for other reasons. The risk is therefore for this to run and with it a further risk to sharpening that bend ahead of the policy makers. 

Let’s take a look at the rest of the deflation trade. The most obvious has been the bond markets. The size of the market is gigantically monstrous and yields are pretty close to zero across many of the key ones. My concern is what happens should opinion on the outlook of inflation suddenly shift due to growth from CB stimulatory policies combined with rising energy prices. Coming from such a low yield base and with such huge consensus any exiting of positions could be messy as it is unlikely that there are many people left looking to buy. This could very easily look like 1994 again. 

If we do get a 1994 the effect this time could be much more dramatic and would derail central bank policy and place huge burdens on the elephant  diplodocus in the cupboard. All the bonds that central banks and funds hold. 

As I have regularly remarked, equity prices are not expensive when measured against alternative yields and as such I have been dismissive of traditional measures of earnings and dividends versus price suggesting that equities are toppy. However if we get a serious tip in bonds then that argument vanishes. In which case equities would get caught up in the sell off. 

So where as we saw equity and bond price inflation in the deflationary QE era, we could well see equity and bond price deflation in response to a shift to perceived inflation. Of course whilst this in itself will act as a brake on inflation, it does make one ask where one wants to have ones money parked in a bond AND equity selloff. 

Which brings us back to cash and a safe haven currency that isn’t going to be sold off like mad in this panicky scenario. Take your pick, but a low debt issuing country running twin surpluses would be sensible. There is an alternative and though this goes against my grain, I guess as most of what I have written above could be considered Zero Hedge fodder, let's go the whole hog and suggest buying gold. There I've said it. 


MagicC said...

I think the Fed has shown admirable resolve and foresight in forestalling the rate hikes that the panicky inflationistas demanded in 2010. I expect that they will show similar equipoise in response to the deflationistas of 2015.

If we have learned one thing in the Great Recession that has lasting resonance among Right and Left alike, let it be the primacy of Core Inflation over headline inflation. A quarter-point increase in interest rates in 2015 will not destroy us, assuming unemployment is back to sub-5% and Core Inflation tracking toward 2% before that rate hike is implemented. And if these numbers don't come to pass, I have confidence that this evidence-minded Fed will show the proper Patience.

Corey said...

Boom, effing boom man. That was the sound that went off in my head when I read the penultimate sentence. I agree with MagicC the Fed and other CB's seem to be consistent - at least so far - on energy price spikes. I think you make a very valid point tho regarding growth/inf, recession/defl. And the conclusion makes sense - if US QE was good for stocks and bonds (bad for cash) then why wouldnt the reverse be true. But, if memory serves Europe was mired in disinflation prior to the crude plunge. Seems likely that excess capacity will remain and wage growth will be non-existent until real GDP growth picks up. If as you suggest oil goes back up (soon) then medium term inf expectations wont really have had any time to adjust - US consumers are still saving the proceeds.. Same thing with equities - if they were cheap with US10 @ 2.2 then they will still be if we go back to those levels since it was only a short time ago when we were there. Very surprised at the mention of your diplodocus, CBs are the ultimate leveraged fund with no mtm, no?

Polemic said...

Yes I do agree with both your points re the Fed playing it very sensibly so far, but perhaps it highlights the problem of inflation vs growth expectations.

Corey's point re Europe. yes Europe did have it's disinflation that was associated with it's economy going down the toilet. In this case the disinflation was the flea on the back of European falling growth dog. Since then euro data has flattened and isn't tanking. So if we say the growth disinflation is waning but energy inflation has taken over then in my eyes ECB action is lagging and in fact may be deemed unnecessary in tomorrows history.

With inflation expectations I m not talkimg the Joe on the street wage expectation inflation expectations I mean investor inflation expectations. The folks that have been piling into bonds. If their expectations change, as they always do before wage inflation actually appears, then their could be a fire sale.

And with equities it was a different picture when we were at 10Y 2.2 on the way down growth data was strong and we had growth momentum on equities side. But now we see US data looking worse, a plateau rather than a momentum trend to buy on, and we have equities supported more now by yield differential bonds/eqs as (as everyone keeps pointing out) historic valuations for equities show them rich. Take away the bond yield differential and that richness will have little to support it.

As for diplodocus. OK. lets assume he's not just in CBs cupboard but nearly everyone's cupboard

Corey said...

I dont doubt that there is a surprise in store for those that are loaded up with FI - how anyone can accept duration risk after such a run is beyond me. Fair point on US eq growth and data too.

Could inv inflation exp turn as you say and put Dr. Aghi in a position between maintaing his credibility to do what he said he would do vs what he should? Well then he would just go to a data dependent stance like Madam Janet and who would blame him as long as growth was humming along - wait thats exactly the assumption you're warning against making ;) No, its hard to separate the two, since CBs have made them seemingly equivalent. However, at the lower bound with current debt levels it would seem CBs can only really manipulate the inflation side anyway. Pushing on a string has become flooding the world in (dollars/euros/yen) hoping to lift your boat higher than all the rest, meanwhile giving no attention to holes that were punctured from the last time you hit the rocks. Or perhaps a better analogy would be be calling a pass when you're 2nd and goal instead of handing it off to your running back and having him smash it up the middle for an (almost) guaranteed score and victory. And if seasoned coaches who should know better can still call the wrong play at the most critical of times why should we expect any more from our beloved CBers who are truely scratching out the plays in the sand prior to each down?

But, Europe QE is/was fundamentally different from US. First the effects from QE have already been realized - lower FX, lower rates prior to actual implementation of the program. Dr. Aghi promised us to do whatever it would take and although its always hazardous to argue the counterfactual, he was boxed into a corner and had to pull the trigger on a program that he promised 3.5 yrs earlier. That's the price for European ineffiency plus a little good old German stubborness.

Either way it is sure to be an interesting year.

Polemic said...

Thanks Corey. Good stuff.
I have to say though that it s so confusing you can knit practically any story out of the box of tangled string that we are currently presented with.

I Will Never Accept The Terms of Service said...

Gee, 1994 really sucked bad. And those 5 years after it were even worse!

Polemic said...


Thanks for that. I just about detected a wee touch of sarcasm buried deep in there. I guess you were a bond trader in 94 on the right side of the melt? The next 5 years then were great for equities due to a v different background.

Anonymous said...

Bringing it down a notch. Equipoise. You learn something new every day. Always associated it with this stuff.