Declining Inflation Expectations May Affect the Fed’s Decision
Ray (Dalio) of Hope for Bond Investors or (Bill) Gross Delay in Raising Rates?
Commodity prices have suppressed inflation—and this bothers the Fed
In February 2015, we highlighted the role of commodity prices in suppressing the inflation rate in the US. Our article, Make no mistake, the Fed is the biggest trader in the room, talked about two crucial aspects that affect the US economy and the Fed’s decision to hike rates. These factors, although not as pronounced at the Fed’s meetings, include:
1. the strength of the dollar (UUP)
2. the effect of a rate increase on commodities
The stronger dollar has weakened export competitiveness
A strengthening dollar weakens export competitiveness. Because commodities form one of the major export goods of the US, a stronger dollar would affect the demand for the relatively expensive US commodities in the foreign markets. This would lead to a decline in demand, which would affect commodity prices.
Weaker commodity prices would, in turn, suppress the inflation rate due their role as an input cost of most production. They have already impacted commodity players like Freeport-McMoRan (FCX), Alcoa (AA), and Chesapeake Energy (CHK), but it has now seeped into other areas such as its effect on inflation expectations.
A rate rise could further strengthen the dollar
An interest rate hike would send the dollar higher, as investors would flock to the US stock and bond markets from riskier emerging markets. Currently, historically low interest rates are preventing these kinds of fund inflows as investors tend to park funds elsewhere in search of yield. Most of the dollar’s ascent has come on the back of strong relative economic performance of the US compared with regions such as Europe and Latin Ameria.
Once safe-haven Treasuries start offering yield along with principal security (which they always do), given the rising riskiness in emerging markets such as Russia and China, the increased demand for the dollar would likely lead to further appreciation in the currency.
The consequent lowering of commodity prices could lead to a further decline in inflation expectations in the US. The chart below shows how crude oil prices are closely related to inflation expectations in the US. Inflation expectations in the US (SPY) are well reflected in the spread between the ten-year Treasury yield (TLT) and the ten-year Treasury inflation-protected securities (TIP) yield. The yield spread, or the break-even yield, serves as a good proxy for such expectations in the market.
International developments affect the Fed’s rate decision
Moreover, the Fed is closely watching and has added the phrase “international developments” among the factors that go into making a rate hike decision. With Europe still in the midst of a slow recovery, and China being at the center of the recent market rout, the Fed might find itself in a Catch-22 situation when it comes to hiking rates.
While the markets may be anticipating a rate hike to occur this September, not many are aware of the effect it could possibly have on the Treasury yield curve.
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