Oil Spikes Bring Fear of Rate Hikes

September has been a rough month so far for bonds and rates. Let's discuss the big headlines last week in the financial markets.

Oil Gushing Higher

The price of oil has been on the rise, hitting 10-month highs, due to lower supply levels and production cuts from Saudi Arabia and Russia. This rise has also led to a spike in both jet fuel and diesel. The latter is a concern because we learned last summer how higher diesel prices elevated food inflation as it is everywhere within the food supply chain. Diesel is used in mills, factories, and shipping so if diesel goes higher, food costs are going higher.

Bonds loathe inflation so any news showing that it may be on the rise is bad for rates. And bad it was, the 10-year note yield rose to 4.30%, after touching 4.05% on September 1st.

This news may very well confirm that inflation bottomed out in June at 3% and is creeping higher. The Cleveland Fed is now expecting inflation to rise closer to 4% in September, and their forecast does not include this recent rise in oil, which will undoubtedly make inflation higher still.

There are two ways to lower oil prices. One, global demand slows thereby creating more supply. And two, the U.S. creates more supply. Seeing that the U.S. is not ramping up energy production, we have hope that demand slows to lower prices. The problem? Russia and Saudi Arabia just extended their oil production cuts for another 3 months, which means any demand slowdown could be offset by less supply, hence elevated prices and inflationary pressure.

U.S. Dollar Is Strong

The dollar has been strengthening over the past couple of weeks, as the U.S. once again outperforms virtually all other global economies. Europe appears like it's heading into a recession in the second half of this year. China and other countries throughout Asia are also struggling. This leads to dollar strength. Typically, a strong dollar would help oil prices to some degree, but the production cuts and an already lower supply are keeping oil prices high.

A strong dollar has also created another problem. The yen in Japan, and the yuan in China have weakened sharply against the dollar making imports more expensive. Both countries have spoken out about the need to keep their currency strong. How would they do this? Well, the two countries combined own close to $2 trillion worth of Treasuries. What they have been doing of late and what they could threaten to do is sell Treasuries to purchase their own currency to prop it up against our strengthening dollar. Should this come to pass it could put further upward pressure on rates.

Fed Rate Hike Chances

As of this moment, the chance of a rate hike in September is very small. But the chance of a rate hike in November is about 50% or a coin toss. Should oil rise further it will put pressure on the Fed to raise rates once again. Yes, this is a bad setup as we move into the Fall.

Bottom line: In the absence of a surprise shock to the markets, any relief in rates in the near-term will be minimal and fleeting, much like we've seen over the past several months. Watch 4% on the 10-year note as a pivot point. If the 10-year note yield moves beneath 4%, we will likely see sustained rate relief. The opposite is true.