Projections of Fed rate changes appear misaligned with inflation expectations and GDP growth.
From its 2018 peak on October 4 to its low on Christmas Eve, the price of a barrel of Brent crude oil fell 38%. Since then, it has climbed steadily higher and now sits 42% above its trough.
As the price of oil has moved, so too have inflation expectations. The 5-year breakeven inflation rate is a gauge of inflation expectations – measured by the difference between the yield of the 5-year Treasury bond and the yield of the 5-year Treasury Inflation Protected Security (TIPS).
Similar to the performance of the stock market over this period, the reversal in the price of oil coincides with the Fed’s reversal in its policy stance.
Counter-intuitively, during the second half of April, the futures-implied probability of a Fed rate cut before the end of 2019 has climbed from 39% to 67%.
How can it be that the market expects higher inflation on the one hand, while expecting a Fed rate cut on the other? It seems that one of these projections must eventually be proven wrong.
Rising oil prices and inflation expectations, along with the much-higher-than-expected Q1 GDP growth, may not increase the likelihood of a rate hike any time soon.
If those trends persist, however, it’s difficult to see how they won’t eventually put downward pressure on the likelihood of a rate cut.
Unless otherwise noted, data is sourced from Bloomberg.
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