The Goalposts Shift for Inflation and The U.S. Dollar

US Dollar

Hold on. Did you read what Jerome Powell said this morning? Wait. What? Seriously. Am I hallucinating? Did this really come out of his mouth TODAY? 

“As the magnitude and persistence of the increase in inflation became increasingly clear over the second half of last year, and as the job market recovery accelerated beyond expectations, the [Fed’s Federal Open Market Committee] pivoted to progressively less accommodative monetary policy,” Powell said. “I believe these policy actions and those to come will help bring inflation down near 2% over the next three years.”

Not one year. Not two years. Three years. That’s 2025… That’s a midterm election and a Presidential election away. Wasn’t all this inflation supposed to be “transitory?” It’s been a decade of failure to bring inflation UP to the Fed’s target of 2%. Now the threat is that we’re going to see this wealth-destroying element entrench itself into the economy.

This isn’t moving the goalposts… this is melting down the goalposts and turning them into steel. That’s with the hope that you might be able to sell an inflation-proof asset at a higher price. Powell’s comments have sent expectations for rate hikes into overdrive. 

Target Rate Probabilities

The 10-year bond has pushed above 2.3% in a hurry. The markets largely expect that the central bank will increase its benchmark rate by 50 basis points in May and another 50 basis points in June. Go out a year from now, and a 3% rate level is starting to appear in the range of probabilities in the CME FedWatch tool.

Although the probability sits under two percent right now, I wouldn’t be surprised to see that likelihood surge in the months ahead. This will prove the more hawkish members of the Fed like James Bullard correct. 

Powell has been slow to address inflation, and the central bank is behind the curve. My next concern is that growth expectations start to trickle toward flat or even negative levels for the beginning of next year – a sign of stagflation. The only natural move after is to allow a recession to play out. 

People need answers, not surprises or cans being kicked down the road. So again, I remind you that regional and community banks will remain your friend in this environment. So too will insurance companies, which have benefited from inflation. Why? They’re raising their rates to address the rising prices of assets, which cycles into their balance sheet and profits. 

Playing Commodities 

I get a lot of questions each day around commodities, given the impact of inflation. As I’ve said, there remains a significant supply and demand imbalance in the global oil markets. 

Oil already hit my HIGH TARGET price of $130, largely due to the Russia/Ukraine conflict. But it was the lack of capital in the energy markets that fueled my bullish outlook. As JPMorgan noted in 2019, companies lack the necessary capital to expand drilling around the globe. This capital challenge is a severe issue that will likely accelerate through 2025. 

JPMorgan has said about a $500 billion gap between the amount of capital available and the amount required to fund necessary production and exploration activities through 2025. A massive supply and demand imbalance exists. 

But remember – a stronger dollar will be a bearish factor on oil prices. It might not be significant, but we witnessed a short-term drop in crude prices following the statements made by Fed Chair Jerome Powell. Here’s what happens. When the Fed raises interest rates, it increases the payoff of U.S.-denominated assets like bonds. 

The U.S. Dollar

Investors – relying on the safety of U.S. financial assets, confidence in the dollar, and the full faith of our credit system – will use the 10-year bond as a risk-free rate. When that bond increases, it becomes more attractive, and investors turn away from certain, riskier assets. Of course, it’s not THAT simple, but that’s a good top-level view – and it becomes bullish for the U.S. denominated assets. 

Now, a stronger dollar does rely on basic supply and demand. More demand for dollars does increase the value – as does the massive use cases for that greenback. 

One of the most important is that about 80% to 90% of global oil flows are traded in U.S. dollars. That’s according to a friend of mine who trades oil professionally in Switzerland (Thanks, Neal). Following the collapse of the Bretton Woods agreement, the Nixon administration was able to ensure that the U.S. dollar became the primary instrument of trade in the global crude market. 

That creates MASSIVE demand for dollars since they must trade this asset. In addition, more than 90% of global crude is referenced to the dollar. So, even though some traders might not settle their trades in dollars (they might use Euros), they will still reference the exchange rate of dollars to euros to determine the final settlement price. 

As the Fed raises rates – look for the dollar to improve its position AGAINST other currencies like the Euro, the Loonie, and the Swiss Franc. But keep in mind that the long-term fundamentals for oil (and the lack of capital to boost production) will press crude higher until we see a dramatic shift in how producers respond to the most important incentive of all: Price. The dollar is king.

Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.
Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.

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