Oil complicating the Fed tightening agenda
As previously mentioned, the Fed is trying to stomp out rising inflation expectations from becoming “entrenched” in society. The real time scorecard one can look at to give a hint if they are achieving this goal is by looking at breakeven inflation yields out the curve.
While the Fed likes to look at core measures of inflation and will often remove energy price volatility from their real time view, there is no doubt that oil prices are a major driver of many things in the economy and are a tremendous driver of core inflation as well. We can see this dynamic in play in the below chart of Brent oil vs 5 year breakeven yields. There is a pretty tight historical correlation between oil prices and breakeven inflation yields (the real time proxy for market view on inflation expectations). If oil stays firm (current Brent oil prices are near 5+ year highs), inflation expectations will stay elevated and this will likely mean the Fed needs to do even more to get them under control. While the market has already priced in 4 interest rate hikes for 2022, I continue to be in the camp that says the Fed is more likely to go 4 meetings in a row, starting in March (then May, June, July) as opposed to this narrative that they can only hike every other meeting when a new Summary of Economic Projections is given. An environment where rate hikes are front end loaded and the beginning of the Balance Sheet reduction program by mid-year is something that risk markets are simply not prepared for. While the market has begun to sniff this out in recent days as bond markets continue to sell off and volatility is creeping higher, financial conditions still remain too loose. We remain hedged up with index puts. Tread Carefully.
*Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risk so do you own due diligence.