US Strategy Weekly: Oil, Inflation, and Interest Rates

Global bond yields hit levels last seen in 2008, crude oil prices soared over the worrisome $100 a barrel level, investors remain nervous about AI spending, and AI leaders call for a reining in of AI development. The Houthis announced a number of attacks on Saudi Arabia, one of which knocked out one of the Kingdom’s most important oil transport routes and another that struck an air base. US Space Force chief Douglas Schiess confirms the US does “operate on-orbit weapons that can defend the Joint Force against space-enabled attacks” while the US Senate fails to advance comprehensive cryptocurrency legislation backed by President Donald Trump and the crypto industry. And these are just a few of the issues that color the world financial scene as the Federal Reserve meets this week.

One might wonder why the stock market has not had a more sizeable decline given the rise in both oil and bond yields. After more than a week of falling prices, the S&P 500 is only 2.7% away from its all-time high. The Dow Jones Industrial Average and the Nasdaq Composite are only 4.1% below their highs. The more volatile Russell 2000 index is 6.5% away from its record high, but still up 15.7% year to date. Most popular indices are up double-digits year-to-date.

One reason stocks may be more insulated from oil prices than expected is that the economy is less oil-intensive than it used to be. Energy spending accounted for 5.7% of disposable consumer income in 2024, compared with nearly 10% in the 1980s, according to the American Petroleum Institute. And energy represents around 5.5% of GDP, nearly half of what it was in 2008, according to the US Energy Information Administration. But soaring gasoline, diesel and fuel prices still eat into discretionary spending. This is particularly true in California.

The state of California operates much like an island when it comes to gasoline. The state requires a special blend of fuel that results in lower air pollution to avoid the smog that used to blanket Los Angeles. This combination of California’s unique proprietary fuel blend, declining gasoline demand driven by zero-emission vehicle mandates, and a lack of out-of-state pipelines; means California has lost 17% to 20% of its refining capacity due to the structural shutdown of Phillips 66’s Los Angeles refinery (139,000 b/d) and Valero’s Benicia plant (45,000 b/d). As a result, the state relies heavily on foreign and out-of-state fuel imports. This adds to the prices increases seen in California. In addition, when combining all state levies, local taxes, environmental programs, and federal mandates, the total cost allocated to taxes and fees on a single gallon of gas is roughly $1.20 in California. See page 6 for more details.

But in general, the housing market could have an even bigger impact on the broad economy than oil. The housing market represented nearly 16% of GDP in the second quarter when one includes a cross section of construction, home improvements, rents, and fees. The residential real estate market has been sluggish for nearly four years, and rising interest rates are not going to help.

With regard to this week’s FOMC meeting, we do not believe recent inflation data alone guarantees a rate hike. Headline CPI in August was 3.4% YOY and unchanged from July. Core CPI was 2.4%, down from 2.5%. These were moderate numbers. See page 3. However, the PPI for final goods jumped 5.4% YOY in August, up from 4.8%. This uptick was driven by the energy index which rose 16.3% YOY, up from 14.7% YOY. What is more important is that crude oil prices are up dramatically from the end of August, and this suggests inflation data will be worse next month. For this reason, we are changing our view and expect the Fed will raise rates. This is the consensus view.

A Fed rate hike will not have any influence on the price of crude oil since this is a supply problem, not a demand problem. Still, we expect markets to react poorly if the Fed fails to raise rates. In the aftermath of the meeting, the reaction of the 10-year Treasury yield will be the most important factor to monitor. Shortly after this meeting we expect a debate will begin over whether this will be a one-off rate hike or the beginning of a series of rate hikes.

The charts on page 4 may help explain the angst related to the Fed raising rates. Fed policy changes were frequent from 1950 to 1988. But beginning with the chairmanship of Alan Greenspan (August 11, 1987 to January 31, 2006), who stepped in just before the Crash of 1987 and successfully dealt with that crisis, a policy of longer and more strategic programs of easing and tightening commenced. In the last twenty years there have only been two tightening cycles and no one-off rate hikes. The December 2015 to December 2018 cycle saw an increase from a low in the fed funds range of 0% to 0.25% to a high of 2.25% to 2.50%. The second cycle was from March 2022 to June 2023 from a fed funds low of 0% to 0.25% to a high of 5.25% to 5.5%.

In between these two tightening cycles, the real fed funds rate was negative (lower than inflation), and monetary policy reached its “easiest” level in 75 years. Specifically, in March 2022 the fed funds rate averaged 0.38% and the CPI reached 8.5% YOY for a negative real fed funds rate of 8.2%. It was a tragic miscalculation by the FOMC at that time, and it let commodity-led inflation shift into the service sector. See page 4. Overall, investors have experienced unusually easy Fed policy in the last two decades and have relied on Fed policy to support the economy and the stock market. Chairman Kevin Warsh is looking to change this dependency and the blowback is interesting. 

A 65-year chart of government interest rates (page 5) shows how extraordinary the last 25 years have been for investors. Interest rates have been in a secular decline since 1981, and interest rates have generally remained below the 4% level for most of the last two-and-a-half decades. However, many economists are questioning whether this long cycle of declining interest rates is over. We would add that there are reasons to believe commodities are in demand throughout the world, which implies higher commodity prices and more inflation ahead. Both are likely in our opinion. If this is correct it will require a change in long-term investment strategy.

But overall, the fear regarding the level of interest rates and the slope of the yield curve is overdone in our opinion. The inverted yield curves of December 2022 and December 2023 were the worrisome curves since inversion is a sign of a potential recession. This was followed by a flat yield curve in 2024 which is a classic sign of a weak economy. The current slope of the yield curve is right in line with the average yield curve, and it remains below average levels. See page 5. In sum, there is no reason to panic. And while we expect a Fed rate hike this week, it could be a one-and-done if the war in the Middle East is resolved. September and October tend to be the weakest months of the year, and this is particularly true in midterm election years. However, a year-end rally tends to materialize regardless of the election outcome. Investors should prepare for volatility and opportunity.

Gail Dudack

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