If delivering a dovish hike is no longer possible, then the Fed could end up causing higher real rates
As we and plenty of others have noted, there’s a very real risk that the Fed is about to make a policy mistake by hiking into a growing deflationary impulse.
We discussed this at length over the weekend in “Yeah, So The Fed Is Going To Hike Into A Deflationary Backdrop.” Key to that post was BofAML’s observation that “since 1957 there have been 722 overlapping two-month periods [and in] only six of these have we seen core CPI deflation – but that includes the most recent March-April period this year.”
At issue is whether the Fed should tap the brakes and wait for realized inflation to materialize rather than focusing on the (ostensibly) overheating labor market and the possibility that waiting any longer to normalize risks blowing even bigger bubbles in risk assets.
On Monday, BofAML is out with another interesting take on this, noting that the combination of dovish expectations and poor incoming data makes for a potentially dangerous setup. In short, delivering a “dovish” hike like that we got earlier this year may be well nigh impossible as expectations are already as dovish as they can conceivably get. Meanwhile, the lackluster data increases the chances of a policy mistake.
The argument is that if delivering a dovish hike is no longer possible, then the Fed could end up causing higher real rates, which might weigh on commodities (which are already facing headwinds) and that, in turn, could feed back into realized inflation and inflation expectations in a kind of double whammy scenario.
For that reason, BofAML thinks that “if the Fed hike this week triggers another leg down in commodity prices,” that will be the warning sign the they’re “sleepwalking into a policy mistake,” as the focus would quickly shift to demand conditions (as opposed to oversupply). More below…
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Oil is the Fed’s canary
This interest rate hiking cycle has been different…
Historically, late cycle inflation pressures have forced the Fed into a faster pace of nominal rate hikes. In turn, higher nominal and real rates have often had a dampening effect on real economic activity. Yet this cycle has been different. Following an exceptionally long period of zero interest rate policy (ZIRP), the Fed stopped growing its balance sheet in late 2014 (Chart 1) and then gently started hiking interest rates in December 2015 (Chart 2). Our economists now expect the Fed to hike by 25bps at roughly 3 to 4 month intervals until interest rates normalize. With a projected terminal Fed funds rate of 2.75-3.00, the current rate hiking cycle could go on for two to three years. In essence, the Fed has pledged to remove monetary accommodation only at a very slow pace in fear of hurting a frail recovery.
…but can the Fed continue to deliver dovish hikes?
So far, real rates have fallen even as nominal rates rose—a new phenomenon often described as a “dovish” hiking cycle (Chart 3). But can the Fed continue to deliver “dovish” hikes? Our rates strategists do not seem to think so. With interest rate markets pricing in a 90% chance of a hike next week, they believe the Fed could be setting the stage for a policy mistake. Their argument is that never have forward expectations been so dovish (Chart 4), inflation break-evens been so beaten down, and data surprises been so negative ahead of a Fed hike in this cycle. They think the former makes a dovish hike nearly impossible while the latter accelerates the policy mistake trade. In a Commodity Strategy piece, we recently concluded that a dovish rate hiking cycle could paradoxically be a double positive for commodity prices. By disaggregating the impact of rising rates into its components, inflation and real rates, we concluded that rising inflation expectations and falling real rates are both bullish commodities.
Commodities perform poorly on rising real rates…
Yet our rates strategists argue that opposite seems to be happening. For starters, as a number of Trump administration initiatives such as tax and health care have stalled, economic growth expectations have fallen. Also, gasoline prices are already down year on year as OPEC production cuts have failed to remove the oil inventory overhang, acting as a drag on inflation (Chart 4). Moreover, a fast and furious recovery in US shale oil production YTD suggests we are witnessing yet another technology-induced deflationary episode. With expectations already stretched, a less accommodative Fed that accidentally creates a higher real rate environment could further exacerbate the recent drop in commodity prices. We have previously found that rising real rates are associated with negative commodity beta returns, and falling real rates are associated with positive commodity returns (Chart 5). Moreover, changes in commodity prices can mechanically cause big swings in realized inflation, but can also drive expected inflation near term, exacerbating the Fed’s problem.
…so another sell-off may signal a policy mistake
Real rates have a causal impact on commodity prices due to a variety of transmission channels. Demand for consumed commodities like oil and base metals tends to fall when real rates rise all else equal, as it makes consumption of energy intensive goods harder to finance. Higher real rates also tend to be associated with a stronger USD, which can hurt consumption of energy intensive goods in EM countries. True, periods of high nominal yields have been associated with higher commodity returns during the past 20 years, as economic expansions tend to be characterized by both strong commodity demand and high nominal interest rates. However, periods of ultralow nominal interest rates have been linked to very poor commodity performance since the Global Recession (Chart 8), as commodities need healthy global nominal GDP growth to move higher. So far, the commodity markets have assumed oil prices are lower because of a supply glut. However, if the Fed hike next week triggers another leg down in commodity prices, the focus may turn on demand conditions. Should the Fed be sleepwalking into a policy mistake next week, commodities may provide some warning signs.