Tag: Energy CPI

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Asian Stocks Plunge on Fed Rate Hike Fears

Key Points

  • Headline CPI increased to 3.7% for the 12 months to September, up from 3.4% in August.
  • Energy prices rose 20.4% year-on-year, signaling stronger inflation ahead.
  • Financial markets now expect at least a 25-basis-point rate hike in December.
  • Investors reacted to the threat of higher interest rates slowing the AI rollout, with the Philadelphia Semiconductor Index falling more than 4%, and South Korea’s KOSPI index shedding more than 8.0% in Thursday trading.
  • The IMF’s quarterly Financial Stability Report this week also highlighted the potential for market turmoil, citing a correction in AI-related asset prices, rising sovereign debt yields, and the impact of AI frontier models on cybersecurity as key risks.

The headline consumer price index increased to 3.7% for the 12 months to September, up from 3.4% in August. Core CPI (excluding food and energy) increased to 2.6% from 2.4% in August.

CPI & Core CPI - Annual

Energy prices climbed 20.4% (right-hand scale below) over the 12 months, warning of a sharp rise in CPI that tends to follow with a 1- to 2-month lag, as in 2021-2023 below.

CPI & CPI Energy - Annual

Gasoline prices remain high, at $4.33 per gallon on October 12.

EIA US Gasoline Prices

Diesel eased slightly to $6.18 per gallon on measures to ease the shortage ahead of the November midterms. However, reserve releases aren’t a long-term solution, and the Persian Gulf conflict will likely drag on into next year.

EIA US Diesel Prices

Financial Markets

Several Fed speakers have hinted that the Fed won’t raise rates at the October (27-28) FOMC meeting, but will hike again in December (8-9). The 2-year Treasury yield jumped to 4.95% after Thursday’s CPI report but has since settled at 4.70%. That is still 70 basis points above the Fed’s current target range of 3.75%-4.00%, implying at least 3 more 25-bps hikes.

2-Year Treasury Yield (CNBC)

High-yield bond spreads have jumped more than 2.0% since Kevin Warsh’s keynote address at Jackson Hole on August 28, to above 12%. Widening spreads warn of likely distress among small- and mid-cap borrowers when their current debt matures and they must roll it over at much higher rates.

High-Yield Bond Spreads

Stocks

The Russell 2000 Small Caps ETF (IWM)2 is testing secondary support at 270 on the weekly chart below, while declining Trend Index peaks signal selling pressure. A breach of 270 would indicate a correction to test primary support at 240.

Russell 2000 Small Cap ETF (IWM)

The S&P 500 remains in an uptrend, but retreated  1.1%, its largest daily loss since July, as the Philadelphia Semiconductor Index fell more than 4%.

S&P 500

A breach of primary support at 11,000 in the Philadelphia Semiconductor Index (SOX) would be a strong bear signal for stocks.

Philadelphia Semiconductor Index (SOX)

Asian Stocks

South Korea’s KOSPI index fell more than 8.0% in Thursday trading.

KOSPI Index

A sell-off in global technology hardware stocks deepened Thursday, with Asian chipmakers tracking Wall Street losses as concerns over further Federal Reserve interest rate hikes, financing of artificial intelligence investments weigh on sentiment.

South Korean chip giant SK Hynix plunged over 10%, while rival Samsung Electronics fell 7.1%.

In Japan, technology investment giant SoftBank Group tumbled 7.9%. Semiconductor testing equipment maker Advantest dropped 6.9%, while chipmaking equipment supplier Tokyo Electron lost 5.4%.

….The declines come as investors grow increasingly concerned that higher borrowing costs could weigh on the massive capital spending required to build out AI infrastructure, putting pressure on technology companies that have benefited from the AI investment boom.

Chief executives of Broadcom and Intel warned on Monday that financing could become a major headwind to the AI boom, with Broadcom’s Hock Tan saying it could be bigger challenge to AI expansion than shortages of chips or electricity. (CNBC)

Treasury Market

10-year Treasury futures caught a bid, with yields falling to 5.10% from 5.30% earlier in the month as funds increasingly flow from equities to bonds.

10-Year Treasury Yield

The IMF earlier warned in its quarterly Financial Stability Report of the potential for market turmoil, citing three salient risks that could be near-term catalysts for a sharp tightening of financial conditions:

First, although core firms in the AI ecosystem have been profitable so far—easing pressure on AI-related equity valuations—weaker or less durable investment and profitability in AI could trigger a correction in AI-related asset prices, exacerbated by rising leverage, concentrated exposures, and circular financing arrangements.

Second, resurgent inflation or fiscal concerns could trigger a sharp rise in sovereign bond yields and spark broader market turmoil given the foundational importance of sovereign bonds. High public debt and rollover risks remain unresolved, increasing the chances that a rise in yields could occur in a disorderly manner, despite stable bond market liquidity and the recent unwinding of some leveraged trades.

Third, cyber threats constitute a growing systemic risk as financial services become more digital and interconnected. For their part, frontier AI models are emerging as both powerful enablers of cyberattacks and critical defensive tools. These risks by themselves do not necessarily threaten financial stability, but they could become a systemic risk—impairments to key financial intermediation and credit provision, with serious negative economic effects—if they are amplified by financial vulnerabilities.

The report also highlighted hedge funds’ highly leveraged repo positions and pursuit of crowded trades that “could amplify market stress, with spillovers to prime brokers and broader financial markets”.

Dollar & Gold

The Dollar has strengthened on the prospect of higher interest rates, with the Dollar Index testing resistance at 103 before retracing to test new support at 102.

Dollar Index

Gold weakened on the prospect of higher interest rates and a stronger Dollar, and will likely test primary support at $4,000 per ounce.

Spot Gold

Conclusion

Financial markets are unsettled by the threat of higher inflation driving up interest rates, which could interfere with funding of the AI data center rollout. Stocks are selling off as investors move into bonds, which has lowered the yield curve by roughly 20 basis points in a few days.

South Korea’s KOSPI and Japan’s Nikkei indices are falling, and a Philadelphia Semiconductor Index (SOX) breach of primary support at 11,000 would be a strong bear signal for US stocks.

A Bitcoin1 retreat below support at 80,000 would confirm a market shift to risk-off.

Bitcoin (BTC)

The last two weeks of October are typically a precarious time for stocks, as fund managers reposition after the end of the financial year. We advise stock traders to keep stops tight and investors to adopt a defensive stance by shedding more volatile assets.

Rising interest rates and a strengthening Dollar are bearish for Gold, which is expected to test primary support at $4,000 per ounce. However, the underlying forces driving higher rates—inflation, poor fiscal management, and bond market instability— are all bullish for Gold. We remain long-term bullish on Gold and view the current sell-off as an opportunity for steady accumulation.

Acknowledgments

Notes

  1. Cryptocurrencies are the highest-risk asset class, and we analyze Bitcoin (BTC) solely to identify risk sentiment in financial markets. Our analysis is not a recommendation to buy or sell BTC, nor is it a commentary on the merits of cryptocurrency.
  2. We analyze exchange-traded funds (ETFs) to determine market sentiment towards a specific sector, industry, or commodity. The analysis is not a recommendation to buy or sell, nor is it a commentary on the merits of the particular ETF.
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Stabilizing crude oil prices

Volatile crude oil prices damage production capacity and economic growth and cause volatile consumer price inflation.

At the height of the 2020 pandemic, Nymex WTI crude oil prices fell to an unprecedented low of -$13.10 per barrel as demand dried up and oil storage facilities reached capacity. Producers faced a dilemma: either shut down wells or sell at a loss, effectively paying end users to consume their oil.

Nymex WTI Crude

The Department of Energy failed to capitalize on this opportunity to replenish the Strategic Petroleum Reserve (SPR), buying only 21 million barrels of crude over four months. US field production fell from 13 million to below 10 million barrels per day as shale producers shut wells rather than produce at below cost. The damage done to balance sheets meant that it took several years to restore production as prices recovered.

US Crude Oil Production

Russia’s invasion of Ukraine in February 2022 caused a spike in crude oil prices, with WTI crude peaking at close to $125 per barrel. In response, the Biden administration released 290 million barrels from the SPR. This tipped the oil market into surplus despite OPEC+ production cuts, with Nymex crude prices falling below $75 per barrel.

Strategic Petroleum Reserve (SPR)

Shrinking demand from China and rising non-OPEC production, led by the US, has maintained prices at close to $75 per barrel. Now, hostilities between Israel and Iran threaten to escalate to the point that crude oil supplies from the Middle East could be affected.

Joseph Webster from the Atlantic Council argues that the DoE should not hesitate to make further releases from the SPR to stabilize prices in the event of a supply threat. Net crude imports to the US (blue below) have shrunk to 2 million barrels daily from 8 million in 2017, meaning the SPR provides more than 23 weeks of cover if all imports were to be terminated.

US Crude Net Imports

Further releases from the SPR would not only help to keep prices low but also stabilize them, which can be highly profitable for the US government. SPR releases under the Biden administration, at an average of close to $90 per barrel, will net about $20 per barrel if the SPR is replenished at current prices—a profit of nearly $600 million.

Conclusion

Releases from the Strategic Petroleum Reserve (SPR) should be used to stabilize crude oil prices in case of an interruption to crude oil imports. This would likely have four benefits:

First, SPR releases would ensure an interrupted supply to industry and minimize the impact on the economy.

Second, replenishing reserves when prices are low would help to maintain a floor under prices and support shale producers, avoiding the shut-down of wells when prices fall too low to cover operating costs.

Third, stabilizing energy prices can be achieved at no cost to the taxpayer. Selling when prices are high and buying when prices are low will likely show a profit.

Lastly, SPR releases would help to keep a lid on inflation. Energy prices impact the consumer price index directly through gasoline and heating prices to the consumer but more significantly through the energy cost component of goods and services. The chart below shows how energy CPI (orange) increased ahead of headline CPI in 2021 and similarly led the decrease in 2022-2023.

CPI & CPI Energy

Acknowledgments

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What really drives inflation?

Every month, after the FOMC meeting, Fed Chairman Jay Powell fronts the media and tells everyone how the Fed is determined to maintain the fed funds rate in the same 5.25% – 5.50% range in order to contain inflation. But he is well aware that the Fed funds rate has had close to zero impact on inflation.

CPI peaked in June 2022 when the fed funds rate was an eye-watering (sic) 1.25%. CPI then plunged sharply when the Fed was still in the early stages of hiking rates. The lag between rate hikes and the resultant decline in inflation is normally 12 to 18 months. Now the Fed would have us believe that CPI declined in anticipation of rate cuts.

CPI & Fed Funds Rate Target (Minimum)

Financial conditions did tighten when the Fed introduced QT, with the Chicago Fed Financial Conditions Index (FCI) rising to -0.1%. But then FCI started a sharp decline in June 2023, when the Fed was still hiking rates, indicating monetary easing.

Chicago Fed Financial Conditions Index

Rising interest rates and tighter financial conditions had even less than usual impact on consumer spending because of a strong upsurge in personal savings during the pandemic. A large percentage of government transfers were not spent but went to increase bank deposits.

Government Transfers & Commercial Bank Deposits

Energy is driving inflation

The primary cause of the strong upsurge in CPI in ’21/22 was energy prices. The chart below shows how energy CPI (orange) led CPI (red) higher, reaching a peak of 41.5% in June 2022 — the same month that CPI peaked at 9.0%. Energy prices then plunged to a low of -16.7% in June 2023. CPI followed, reaching a low of 3.1% in the same month. Since then, CPI energy has recovered to close to zero, producing a floor in the annual CPI rate.

CPI & Energy CPI

Energy CPI is a relatively small component of CPI — 6.6% of total CPI — but it is a major cost component of most other variables. Food, for example, requires energy for planting, irrigation, harvesting, processing, refrigeration and transport. Cement requires energy for heating limestone in kilns, crushing and transportation. Steel needs energy for extraction and transport of iron ore, smelting and transportation. Even online services. The latest AI data centers require up to 1 GW of electricity capacity — enough to power 300,000 homes.

The most important determinant of energy prices is crude oil. Nymex light crude peaked between March and June 2022 at prices of $100 to $120 per barrel before commencing a prolonged decline to between $70 and $80 by December of the same year.

Nymex WTI Light Crude

Conclusion

Raising the fed funds rate has had little impact on actual inflation. Rate hikes are more about restoring the Fed’s credibility as an inflation hawk after a disastrous performance in 2021. High energy prices and easy monetary policy and were a recipe for inflation.

CPI & Fed Funds Rate Target (Minimum)

The sharp decline in CPI in the 12 months to June ’23 was caused by falling energy prices. Energy CPI fell from an annual increase of 41.5% in June 2022 to a low of -16.7% a year later.

Nymex light crude has now broken resistance at $80 per barrel. Expect retracement to test the new support level but respect is likely and would confirm another advance, with a target of $90 per barrel.

Nymex WTI Light Crude

A sharp rise in crude prices would be likely to cause a significant upsurge in CPI — and long-term interest rates. With bearish consequences for stocks and long-duration bonds.



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