Bond prices rose last week and are opening higher today as investor angst over lower Chinese growth and worries over the fiscal health of emerging market economies led to a violent risk-off trade. This, coupled with a sharp decline in energy prices, has created a strong bid for high quality U.S. bonds. For energy specifically, WTI crude oil closed Friday at $40 per barrel (down from $90+ at this time last year), a new cycle low. Part of the reason for the sharp decline has been increasing supply. Despite the plunge in prices this year, oil producers have actually increased production in a bid to retain market share.
The price decline has led to lower inflation expectations by investors. As seen by the pricing in TIPS, inflation is now expected to average 1.54% over the next 10 years, down from an expectation of 1.94% just a few months ago.
U.S 10-year TIP Breakeven Rate
This market action is unlikely to sit well with the Fed as they approach their September meeting. The criteria they set for raising rates in September included stable financial conditions (the stock plunge goes against this) and inflation firming (the fall in commodity prices goes against this). It remains to be seen whether or not the Fed proceeds with the proposed tightening, but in our minds, the factors supporting the “yes” camp keep diminishing.
Source: Bloomberg, WSJ