Investors should keep a watchful eye on commodities to gauge whether the U.S. Federal Reserve is “sleepwalking” into a policy mistake that risks derailing the U.S. economic recovery, according to Merrill Lynch.
Investors should keep a watchful eye on commodities to gauge whether the U.S. Federal Reserve is "sleepwalking" into a policy mistake that risks derailing the U.S. economic recovery, according to Merrill Lynch.
Since the Fed started to raise borrowing costs in December, 2015, interest rates adjusted for inflation have fallen as benchmark rates rose, a phenomenon known as a "dovish" hiking cycle, Francisco Blanch, head of global commodities and derivatives research at Merrill, wrote in client note. But with inflation expectations falling and economic data surprises tilted toward the negative, the discrepancy between real and nominal rates may change.
The failure of U.S. President Donald Trump's tax and spending initiatives to get off the ground is weighing on the economic recovery, while lower oil prices are acting as a drag on inflation. In a deflationary environment, real rates may start rising as the Fed tightens, triggering a drop in commodity prices, Mr. Blanch wrote.
Higher real rates are historically associated with falling commodity prices as the cost of financing energy-intensive goods rises, driving down demand, while a stronger U.S. dollar hurts consumption in emerging-market countries. In turn, swings in the prices of raw materials such as oil can sway inflation, complicating the Fed's policy considerations.
Others, including Citigroup Inc., sees things differently – arguing the central bank may need to hike sooner to offset loosening financial conditions.
Economists see two additional Fed rate hikes this year, starting with the June 13-14 meeting, according to the median estimate in a Bloomberg survey of 43 economists. Merrill Lynch expects the Fed to raise rates by 25 basis points at three- to four-month intervals over the next two to three years, until the Fed funds rate reaches 2.75 per cent to 3 per cent.
"With rate markets pricing in a 90-per-cent chance of a hike, and inflation break-evens so beaten down, delivering another 'dovish' hike seems difficult," Mr. Blanch wrote. "Dr. Copper and Dr. Oil are the Fed's canaries."