FOMC: Oil Supports Fed’s Gameplan

Carnage in the oil market spells trouble for the short-end of the Treasury curve.

The FOMC Minutes from the December policy meeting reinforced the message that plunging oil prices and eroding market-based inflation expectations are not reasons to alter the Fed’s expected policy timetable. Oil’s impact on inflation should be temporary, and solid labor market momentum will justify a mid-year start to the tightening cycle. Indeed, some FOMC members suggested that the “…boost to domestic spending coming from lower energy prices could turn out to be quite large.”

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As for inflation pre-conditions, the FOMC set the bar low; the door to rate hikes is open as long as core inflation does not fall and policymakers are “reasonably confident” that it will reach the 2% target by 2016 or 2017.

One of our lingering concerns last year was that the U.S. economy might not be able to sustain above-trend growth throughout 2015. However, the oil shock changes the growth calculus. We agree with the FOMC that the stimulus from cheaper oil will provide a substantial lift to growth this year, despite the hit to the domestic energy patch. The positive supply shock comes at a time when interest rates are low, consumer deleveraging is well advanced and the labor market is humming.

The short-end of the Treasury curve is vulnerable if the FOMC is indeed on track for a mid-year rate hike. The market is discounting a path for policy tightening that is later and slower compared to the Fed’s roadmap. The FOMC attributed this divergence to a low term premium and/or a greater weight assigned to less favorable economic outcomes in the money market. It is difficult to disentangle those two explanations. Nonetheless, the implication is that short-term Treasury yields have a lot of upside potential if the Fed’s economic forecasts are realized. Market expectations for a September start to the rate cycle will likely shift closer to June in the coming months.

It is a different story at the long-end of the curve, which has been dominated by global events in recent weeks. A bottom in the 10-year yield will likely require some combination of the following:

  • a bottom in oil prices;
  • the ECB announcement of sovereign QE, followed by some positive economic surprises in Europe; and
  • policy stimulus in China that stabilizes asset prices in emerging markets.

The first two items could fall into place in the next couple of months, although long-term Treasury yields do not have much upside given the global backdrop.

(Part I) U.S. Equity Bull Market: Is The End Near?

Cyclically, U.S. equity market behavior resembles a late-stage bull market, characterized by narrowing breadth and declining correlations.

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One of two cyclical scenarios is likely to play out on a 6-12 month horizon. The preferred scenario of our U.S. Investment Strategy service is that the cyclical bull market persists in 2015, as the “generous liquidity” stage only slowly transitions to an earnings growth driven phase, keeping U.S. macro volatility low. In this case, the late-stage bull will be characterized by narrowing breadth, with yield plays a potential bubble candidate as Treasury yields respond to weakness abroad and dollar strength.
This pattern of narrowing breadth played out during both the NASDAQ and housing bubbles. The former bubble in the late 1990s is particularly instructive for the current environment, because it was given a jumpstart by weakness abroad that kept the Fed generous. In 1998, with the help of the “Greenspan put”, healthcare, consumer staples, banks and technology were all bull market leaders. But by 1999, only tech was rising.
Alternatively, a cyclical bear market could begin in response to Fed tightening and/or EM deflation, if they are sufficiently intense and prolonged. Granted, the Treasury yield curve is flattening and earnings revisions are the most negative in 24 months.
Nevertheless, it seems too soon to expect a bear market. The oil price plunge increases the Fed’s room for maneuver by widening the wedge between economic growth and inflation.
Even if a cyclical bear market does not emerge next year, intermediate-term forces are gathering for a potentially severe correction.