Some folks are concerned about the possibility that Donald Trump’s (probably) ill-advised decision to exit the Iran nuclear deal is going to stoke inflation on the back of surging crude prices.
Oil at three-and-a-half-year highs is set against late-cycle fiscal stimulus in the U.S. and the prospect of tariff-related price pressures. Clearly, the question is whether all of that together might be enough to cause problems. One thing worth noting (and really, there’s an argument to be made that given the myriad structural drags on inflation, this is the only thing worth noting), is that the “problem” here isn’t so much the fear of runaway inflation as much as it is the prospect of the Fed overtightening in an effort to ensure inflation expectations don’t become unanchored. Overtightening risks inverting the curve which in turn raises the specter of a recession, etc. etc.
This is ultimately what’s allowing the dollar and crude to rise together. As Deutsche Bank put it months ago, “what complicates things is that the behavior of real rates at this point is also a function of expected inflation: Higher inflation warrants a more hawkish Fed and therefore pricing in higher real rates.” Well, a more hawkish Fed underpins the dollar and although the EM mini-rout took a breather this week (five-day rally for EM equities and the MSCI EM FX index closed the week on a decent note), recent outflows and the still pressing concerns in Argentina and Turkey mean developing nation assets are likely to remain on edge until there are compelling reasons to believe that the dollar rally has run its course.
This is why folks have been rolling out the breakevens versus crude charts so much lately. Here’s the longer-run view:
And here’s the 5-day which appears to suggest that the link broke down a bit on Tuesday afternoon amid the absurd headline hockey that preceded Trump’s official announcement, but you get the idea.
Of course no matter how hard one tries, it’s impossible to anticipate all of the second-round effects of the dynamics described above, but what it is possible to say is that higher prices at the pump have the potential to put consumers in a bad mood.
If what you see in the following chart continues apace, it’s not unrealistic to suggest that higher crude prices could end up effectively negating some of the boon from the tax cuts in the U.S.
So what does history tell us about Mideast tension and the read-through for crude and inflation? Well, a straightforward assessment (i.e., one that ignores the second-round effects mentioned above), tells us the following, as laid out succinctly by Barclays in a note dated Friday:
While the long-term implications of withdrawal are unknown, there could be immediate adverse consequences for the global recovery, particularly if oil prices rise sharply. That said, the history of market reaction to Middle East tension has been mixed: while oil prices rose sharply following the OPEC embargo and Iranian Revolution, the response has been more muted recently, perhaps due to mitigating factors such as swing producers (Figure 1). But even a 20% rise in the oil price by the end of 2018 – almost twice as large as has occurred following recent events – would likely have only a limited effect on 2019 CPI inflation (Figure 2). While this mechanical calculation ignores second round effects, greater recent reliance on shale oil could be an important mitigating factor. Overall, we believe that the direct effects on CPI inflation will likely be limited.
So there’s that. But what about the potential for rising oil prices to undercut Trump’s #MAGA “miracle” (scare quotes there for a reason)?
There again, Barclays is pretty sanguine, noting that “historical evidence points to a sharp slowing in US durables consumption when the three-month annualized change in CPI inflation exceeds 9.0% [and] we are far from this rate of inflation in the US presently.”
Right. The bank also notes that the fiscal impulse from the tax cuts and the extra spending should overwhelm rising crude prices when it comes to economic activity in the U.S., but ironically, that raises more questions than it answers about inflation.
“The market is taking on board a view that the US will have a large fiscal inspired demand side shock that will more than offset any negative oil supply side shock, unlike much of the rest of the world, and the demand and supply side will provide a double whammy for US inflation pressures,” Deutsche Bank wrote last month, in a separate note from the one mentioned above..
Now we’re right back to the original question. How fun was that?