I recently wrote about my scenario for a market top in 2016 (see My roadmap for 2016 and beyond), which goes something like this:
- Unemployment is now at 5.0%, which is a point at which the economy historically started to experience cost-push inflation.
- Inflation edges up, which is already being seen in commodity prices.
- Initially, the Fed is content to let inflation run a little “hot” because of what it perceives to be slack in the labor market, but as inflation and inflationary expectations tick up…
- The Fed finds that it is behind the curve and responds with a series of rapid rate hikes.
- The economy slows and goes into recession.
- Stock prices fall as the probability of a recession spikes and a bear market begins.
It’s not oil, it’s the Fed
This is a case of correlation does not equal causation. The framework of that question is actually incorrect. It isn’t rising oil prices that cause recessions, it’s the Fed’s response to rising oil and other commodity prices that slow the economy.
The chart below shows the relationship between industrial commodity prices (blue line) and the Fed Funds rate (black line). In each of the recessionary episodes, we have seen Fed Funds rise in response to signals of rising inflationary pressures from higher commodity prices.
Consider the chart of the CRB Index below. Assuming that commodity prices rise modestly by Q4, the CRB will be positive on a YoY basis by then. How far does it have to rise before the Fed turns decidedly hawkish?
Monitoring Fedspeak for clues
We return to the key question of Fed interest rate policy. I interpreted the April FOMC statement as the Fed’s attempt to tell the market that the June meeting is “live”, though data dependent. But the Yellen Fed’s communication policy is to avoid surprising the markets and the markets shrugged off the April statement and the market implied probability of a June hike barely budged.
Tim Duy thinks that the Fed is about to become more hawkish:
They can change their story within the scope of six weeks. Just like they did from the December to January meetings. And they have the one good reason to change the story: The dramatically change in financial market conditions.
The tightening in financial markets during the winter was the proximate cause of a more cautious Fed. The data didn’t help, to be sure, but more on that later. The combination of a surging dollar, collapsing oil, and a stock market headed only south signaled that the Fed’s policy stance has turned too hawkish, too fast. The Fed relented and heeded the market’s warnings.
But things are different now. US stock market rebounded. The dollar is languishing. And oil is holding its gains, despite disappointment with the lack of an output agreement.
This improvement will not go unnoticed on Constitution Ave. Even among the doves.
We shall see. I will be waiting and watching the tone of the Fedspeak in the days and weeks to come, starting with the Atlanta Fed conference on market liquidity this week.
My base case scenario calls for the Fed to get serious about tightening monetary policy late this year as the commodity prices start to pressure monetary policy. At that point, watch for the narrative to change to “the Fed is behind the curve”.
On the other hand, the turning point could come soon, or later. My inner investor is watching developments and keeping an open mind.