The oil price cliff dive will end the prospect of double-barrelled tightening

Oil has entered a bear market. And despite a large draw in inventories reported today, the decline continued. I think this puts one more nail in the coffin of the Fed’s proposed double-barrelled tightening, where it reduces its balance sheet and raises rates at the same time. More likely, the Fed will pause on hikes and roll off its balance sheet.

So far, as far as credit markets are concerned, there’s nothing to panic about. The continued collapse of the shale oil bubble, propelled forward by low rates, means the oil capex bust is not over – not by a long shot. And that’s negative for the oil sector – but nowhere near as bad as it was when the first downdraft happened a couple of years ago.

So far, while non-investment grade oil names have sold off in bond markets, ex-energy spreads are actually tightening.

I’ve said so far twice because it’s still early days. But let’s also remember that Argentina just sold 100-year paper for a yield of under 8%. That does not speak to risk-off sentiment, which is encouraging regarding the potential impact of an oil sector rout.

But how will the Fed react, you say? To date, it has threatened to raise interest rates and shrink its balance sheet at the same time, despite not hitting its inflation target for nearly 5 years. NY Fed President Dudley says this is because, otherwise “the economy would crash to a very, very low unemployment rate.” And apparently, that’s not good because it would precipitate inflation.

The prospect of this double-barrelled monetary tightening has caused the yield curve to flatten. And a lot of economists have expressed disquiet at the Fed’s hawkishness, including Larry Summers, Janet Yellen’s erstwhile rival for the Fed Chair.

Something’s gotta give. Either the Fed will relent or long-term rates will rise. With oil prices cliff diving, it seems unlikely that broad measures of inflation will climb upward. This means core inflation could fall further below 2%.

This chain of events now spells the end of double-barrelled tightening, something I have been conjecturing would happen for a few weeks now. But last week, when the Fed raised rates I also said this:

The REAL question now is whether the Fed will pause but STILL begin balance sheet reductions, or whether pausing means no reduction

— Edward Harrison (@edwardnh) June 14, 2017

My view: the Fed will use balance sheet reductions to tighten even if it pauses, and then watch what happens to the yield curve

— Edward Harrison (@edwardnh) June 14, 2017

And now Philadelphia Fed President Harker says this is one scenario under consideration at the Fed:

The Philadelphia Fed president is a rate-setter on the Federal Open Market Committee this year. He has been at the hawkish end of the policy spectrum in arguing for rate rises. He acknowledged the central bank’s policy forecasts were “a little more aggressive” than what the market had priced, stressing that “if in fact inflation is softening then I would revise my stance of policy”.

There may “possibly” be one more rate increase this year according to Mr Harker’s forecast, following on from the rises in March and June.

One scenario would see the Fed starting to phase out reinvestments before it went ahead with another rate rise, he suggested.

“It is prudent for us to pause on the next rate increase; at some point, and I would assume it is this year, cease reinvestment; and see how the markets react. We can take our time to do this. We don’t have to be in a rush.”

Mr Harker was speaking in his office following a tour of the Philadelphia Shipyard, which has been using an apprenticeship programme to bolster supply of skilled workers. The central banker said that there was “very little slack” left in the jobs market and that the so-called Phillips Curve, which relates low joblessness to inflation, would eventually kick in. “There is a rate [of unemployment] below which you are going to start to see a significant acceleration of wages,” he said.

Takeaway: A pause is being considered at the Fed, even by hawkish FOMC members like Harker, who talk about the Phillips Curve and low unemployment leading to inflation. The oil price crash now gathering steam makes this pause more likely.

If the Fed does pause though, Harker says quantitative tightening could still be in play, meaning the Fed would be switching from interest rate policy to its balance sheet as a primary form of tightening – something St Louis Fed President Bullard has been saying for four months.

I think the curve flattening stops if the Fed moves to Reverse QE and away from rate hikes. Yes, if the economy weakens materially, you would still get some flattening. But by ending rate hikes, the Fed would at least take the scenario where it causes a yield curve inversion off the table.

Maybe Bullard’s infamous low dot on the Fed’s Summary of Economic Projections is the right way to look at Fed policy.