General consensus seems to have quickly moved to a view that a Trump administration is going to be inflationary for the US and the global economy. Bonds have sold off and Bloomberg has reported that over $1 trillion worth of bond market value has been wiped out this week alone. 10-year breakeven inflation has widened out by 20 bps since 11/4. 30-year breakeven inflation has widened by 25 bps and 5-year, 5-year forward breakeven inflation has widened out by 24 bps over the past week as well. These are some of the largest moves in several years as the last time we saw a 1-week change in 10-year breakeven inflation this large was in 2012. The question we are asking ourselves today is whether or not this is truly a new trend change in inflation expectations?
One of, if not the highest, correlated series to inflation expectations is gasoline prices. For example, since 2008 gas prices and 10-year breakeven inflation has had an 84% correlation. This is a slightly higher correlation than oil prices have had with breakeven inflation. Since 2008. oil prices and 10-year breakeven inflation has had an 80% correlation. Gas prices and 30-year breakeven inflation has had an 84% correlation since 2010 and 5-year-, 5-year forward inflation expectations has had a 77% correlation since 2007. So what is confusing us at the moment is that gas prices are actually turning over while inflation expectations have shot higher. And we believe there is a compelling case to be made that gas prices could fall further and this is not even considering the fact that the Trump administration could spur further shale oil investments by deregulating parts of the energy industry which would only add to the supply/demand imbalance that already exists.
Not surprisingly, oil and gas prices are nearly are perfect 1 for 1 fit. So if we expect oil prices to fall then gas prices should fall with it. The current domestic supply/demand environment seems to be lining up for a further fall in oil prices. For example, even though oil prices have fallen by 28% since the summer of 2015, US crude oil production has declined by only 10% and is still near 30-year highs. Domestic supply ex-SPR is just slightly off of an all-time high at just over 70 days worth of supply (assuming 19 million barrels consumed per day). Speaking of supply, we have also seen a turn in the rig count as oil prices have stabilized around $40-$50 this year which means production could be accelerating once again. It seems clear to us that the US economy is flush with oil at the moment.
So while oil prices look like they may be kept down by the amount supply already available, the demand for gas is being dragged down by more fuel efficient vehicles. Total miles driven in the US broke out of a multi-year lull in 2014 and today is 5% higher than the previous high in 2007. However, presumably because of greater fuel efficiency, the 12-month moving average of gasoline consumption is at the exact same level as it was in 2007. On a year-over-year basis, miles driven is up a healthy 3.3% while gasoline consumption is up only 1.7%. So people are driving more but that isn’t leading to a commensurate increase in gas consumption.
Current inflation expectations since the election seem to be driven by a belief that the new administration will be able to increase economic growth and thus, inflation. If this does play out, surely we will see an increase in oil and gasoline consumption. However, given the amount of oil supply already available, the improvements in shale oil extraction that have driven down the cost of operation for many drillers, and the fact that gasoline consumption is not rising at the same speed as oil total miles driven because of fuel efficiency improvements, the domestic backdrop doesn’t look very friendly to higher oil prices. And if oil prices and gas prices aren’t increasing than it may be difficult to sustain higher level of inflation expectations as well.
© GaveKal Capital
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