By: Jose Torres, Interactive Brokers’ Senior Economist
Central banks’ efforts to curtail persistent price gains while achieving an economic soft landing were dealt a major blow this morning by OPEC +’s newest actions that are causing oil prices to soar at a time when the ISM Purchasing Managers Index has hit a new cycle low of 46.3. The oil price shock and the ISM data collectively reflect powerful forces supporting higher inflation amidst deteriorating economic growth.
After bouncing along 15-month lows of approximately $70 a barrel for West Texas Intermediate Crude last month and even falling briefly to $65, oil prices jumped to $81.69, a whopping 8% daily gain, after OPEC + announced additional production cuts this weekend. Moreover, energy analysts forecast that oil prices could climb to above $95 a barrel. The cuts involve OPEC + members such as Saudi Arabia, Kuwait, Algeria, and Iraq reducing production by 600,000 barrels a day. This follows an OPEC + decision in October to cut production by 2 million barrels a day, or about 2% of global demand, and occur as Russia’s energy exports have been throttled by sanctions targeting the country in response to its invasion of Ukraine.
The OPEC + announcements sent shares of U.S. oil producers soaring this morning on expectations that higher petroleum prices will boost energy companies’ profits. From a longer-term perspective, higher oil prices make oil fracking in the U.S. more competitive in global markets. The OPEC + announcement, therefore, could lead to an increase in domestic energy production that offsets production shortfalls.
While the announcement may be good news to U.S. energy companies and their shareholders, it is creating another challenge for central banks that are seeking to stymie price increase without sparking recessions. In the U.S., for example, Federal Reserve bank leaders forecast an anemic 0.4% 2023 real GDP growth rate, according to the March Summary of Economic Projections. That was a decline from the 0.5% forecasted in the December summary. Fed leaders in March also forecasted core PCE of 3.6% for this year, up from the 3.5% forecast in December.
While the core PCE excludes oil and food prices, it isn’t immune from the impact of higher energy costs. For example, higher diesel may cause freight fees to increase for goods producers, who may then pass the higher costs on to consumers by increasing their prices. Service providers may also increase their prices in response to higher transportation costs. The inflationary impact of higher energy costs can also tip the economy closer to a recession as consumers may cut back on spending when facing pain at the gasoline pump, which is making the Fed’s efforts of tightening monetary policy to fight price increases without sending the economy into a downward spiral more difficult. For decades, low, disinflationary commodity prices helped the Fed maintain relatively low policy rates.
Manufacturing Weakens Further
This morning’s ISM’s report on manufacturing reached a new cycle low of 46.3, battering expectations of a modest decline to 47.3 from February’s 47.5 level. The new orders and employment segments weighed on the headline number, coming in deeply negative at 44.3 and 46.9, an accelerated contraction from the previous period’s 47 and 49.1 levels. Supplier deliveries are speeding up while work backlogs are slowing as manufacturers trim labor against the backdrop of order books that face pressure. As manufacturers fulfill backorders and experience a decline in new orders, they are scrutinizing their production capacity as they look ahead to the risks of a potential recession.
Markets Rotate Out of Growth
The one-two punch of higher inflation and rising recession prospects is punishing the growthier areas of the market while cyclicals are faring better. The NASDAQ index is down almost 1%, the Dow Index is up 0.7% and the S&P 500 Index is roughly flat. Yields are down across durations as bond traders place more emphasis on recession risk rather than inflation prospects. The two and 10-year Treasury yields are down roughly seven basis points (bps) to 3.99% and 3.43%, respectively. The Dollar Index is down 36 bps to 102.15 as traders fight the Fed by pricing interest rate hikes and a year-end fed funds rate of 4.42%, a 71-bp discrepancy from the Fed’s 5.13% projected year-end rate.
This morning’s data remind us that the inflation conundrum is not over as the commodity complex continues to pose problems against the backdrop of challenging geopolitical quarrels. With services prices continuing to increase, commodity prices that remain in the woods and a banking system that hasn’t made the first page of the newspaper in about a week, investors are now pricing in a 57% chance of a 25-bp hike in May
Stagflation Risks Increase
This morning’s data remind us that the inflation conundrum is not over as the commodity complex continues to pose problems against the backdrop of challenging geopolitical quarrels. With services prices continuing to increase, commodity prices that remain in the woods and a banking system that hasn’t made the first page of the newspaper in about a week, investors are now pricing in a 57% chance of a 25-bp hike in May. At a time of a climbing fed funds rate, slowing labor market conditions and persistent inflation, stagflation is in the cards.
This post first appeared on April 3rd, 2023 on the IBKR Traders’ Insight Blog
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