With US growth fine and inflation picking up, the market is remarkably sanguine about future interest rate moves. In our view, inflation is highly unlikely to present a problem for policymakers in the short or medium term, but the basis on which market beliefs have been changed over recent weeks seems fragile – and is therefore vulnerable to change.
Oil price volatility has exerted a powerful influence on levels of Headline CPI in recent years – both inflationary and deflationary. As the chart below shows, there’s a pretty close relationship between changes in oil price inflation and changes in Headline CPI. The experience of recent years also shows the transitory nature of that relationship: oil prices tell us nothing about underlying inflation pressures, or Core CPI.
The drop in oil prices through 2015 exerted a strong downward pull on overall CPI. But an important difference compared with the 2008/09 period (when oil prices fell by a similar magnitude) is that Core CPI has been accelerating rather than decelerating. Furthermore, the labour market backdrop is significantly different, with average earnings growth having picked up speed.
We cannot know where oil prices are going next, but consensus views (for what they are worth) suggest that the probability distribution is skewed away from a repeat of last year’s 50% fall. If we assume oil prices stay where they are today ($28 per barrel), the drag on headline inflation will begin to ease materially from July (the purple line in figure one) and, of course, will no longer exert any restraining influence by January next year.
The chart below shows this in more detail; as at the end of 2015 (latest inflation data), the effect of energy meant that headline CPI was over 1% lower than it would otherwise have been. The red line shows how this drag would persist even if energy stayed at the end of 2015 level (so by Dec 2016 after 12 months of stability there is no impact on the headline level), and the green shows the possible effect if energy was to increase by 1% per month.
Market attention has been fixated on the downside, to both inflation and growth. All the while, the underlying inflation dynamic has been showing a propensity to rise, not fall. And the economy has continued to expand. The risk of a reversal in the market’s beliefs about both inflation and growth is, therefore, material.
With that in mind, the bond market looks vulnerable. As recently as the final week of 2015, US money market pricing reflected a greater than 50% probability of another Fed rate increase at the March 2016 policy meeting. This probability has now fallen to around 10% – its low point of the past year. To our minds this has been driven more by general asset price volatility (centred on – and simplified to – oil and China) than on a level-headed assessment of incoming fundamental data.
The scope for a reversal of much of this behaviour – and associated equity losses – is pretty high.