Powell Looks Prescient as Oil Price Collapses

(Bloomberg Opinion) -- “One thing I don’t worry about is inflation right now.”

When Federal Reserve Chair Jerome Powell said this during a webcast on April 9, I admit my first thought was that it could end up being a contrarian signal — it’s the risks no one sees coming that are the scariest, after all. Inflation obviously won’t surge with much of the U.S. on lockdown to combat the spread of the coronavirus, but it’s possible that huge fiscal and monetary policy interventions will lead to rapid price growth once the economy restarts.

That prospect will play out in the months and years to come. For now, though, Powell looks like something of a oracle, given the unprecedented collapse in oil prices and its reverberation across financial markets.

Consider the West Texas Intermediate crude oil futures contract for June delivery, which is a bit less wonky than the May contract expiring on Tuesday that fell to as low as negative $40. The day before Powell’s webcast, the June WTI contract rose 5% to $30.17 a barrel. Since then, it has fallen in seven of eight trading sessions to about $14. The world is running out of places to store unwanted crude, with negative prices on Monday highlighting the huge supply-demand imbalance in the market and the continued slide in longer-dated contracts confirming it.

At first, traders across financial markets watched oil in awe but otherwise mostly took the decline in stride. That fortitude showed signs of cracking on Tuesday once it became clear that the supply glut is here to stay. The five-year Treasury yield touched 0.3%, the lowest on record, while the 10-year yield tumbled near its all-time low closing level set on March 9. Those were notable moves considering the world’s biggest bond market has been mostly stuck in place since the Fed announced open-ended purchases of Treasuries a month ago.

Credit the dreaded D-word — deflation — for the sudden risk-off mood across markets. To some strategists, oil is just the first and most extreme example of how the economic standstill will send deflationary shockwaves through markets. If demand from American consumers for goods and services is no longer the bedrock it once was, then Economics 101 dictates that prices have to come down. That would validate Powell’s inflation outlook.

“Without doubt, the impact of oil is particularly acute given physical storage constraints, but similar stories are emerging in other sectors,” Dan Krieter at BMO Capital Markets wrote in a note on Tuesday. “While there may be relatively more physical space to store unsold goods, the effect is the same. Prices will drop, workers will lose jobs, and companies will be downgraded or file for bankruptcy. It is possible financial markets have been underestimating the impact of the unprecedented decline in GDP from Covid-19, and oil is simply the first industry to realize it given physical storage constraints.”

This is a clear road map grounded in microeconomics when investing based on macroeconomics has been anything but straightforward. The U.S. budget deficit may quadruple this year to almost $4 trillion. The Fed has boosted its balance sheet by more than $2 trillion in just more than a month and expanded its emergency lending facilities to include municipal and corporate bonds, among other securities.

At the end of the day, though, propping up debt prices doesn’t necessarily support underlying price growth in the world’s largest economy. The U.S. personal consumption expenditures index, the Fed’s preferred inflation gauge, is projected to have declined by 0.3% in March from a month earlier, which would be the steepest drop in more than five years and mirror the consumer price index data from April 10. The PCE data will be released April 30, the day after the Federal Open Market Committee’s next rate decision.

At this point, there’s not much the Fed can say or do to stoke price growth. Interest rates are already pinned near zero. They’ve bought assets (or at least pledged to) across the board. And yet two-year U.S. break-even rates have been persistently negative since mid-March, while five-year break-evens signal that traders expect inflation of about 0.5% through 2025.

“The Fed has pushed money into the financial system, but if people don’t spend it, if it doesn’t turn over as rapidly as before, it is not inflationary,” FHN Financial Chief Economist Christopher Low wrote Tuesday, giving a nod to Lacy Hunt at Hoisington Investment Management, who has long pointed to the velocity of money as a key variable for inflation and interest rates. “In my mind, deflation remains the more likely risk.”

The Fed probably prefers that U.S. Treasury yields remain positive, and I’d expect the central bank to at least halt purchases if yields from two years and out slide further toward zero. If oil really is a harbinger of deflation, though, even that kind of move might not be enough to buoy benchmark yields. Negative oil prices might have been a shock, but negative interest rates are old hat.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

©2020 Bloomberg L.P.

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