3 numbers spell danger: $100, 3.44, 20
If you think the recovery is firm and the risk of deflation has vanished, look at the three following numbers: $100, 3.44 and 20.
The first, everyone knows, is the price that New York crude oil touched briefly on Wednesday, driven 14 percent higher in just five trading sessions by conflict in Libya and concern over the reliability of supply elsewhere.
The second is the yield on 10-year U.S. Treasury notes, and if you are keeping score, they have dropped a rapid 28 basis points from early February, a drop that is telling you that bond investors do not believe the U.S. economy can easily withstand $100 oil.
The third, that 20 percent, is perhaps the most poignant, as it represents the current level, an all-time high, in the ratio of their disposable income that Americans are getting from government benefits.
That’s right: social security, food stamps, unemployment insurance and the like account for two out of every 10 dimes Americans have once they have paid their tax.
Those three numbers don’t say self-sustaining recovery, they say pressure on consumption, on wages and on asset prices.
They also will put pressure on the dollar and will loom over any attempts to normalize Federal Reserve monetary policy. How on earth do you raise rates or end quantitative easing if gasoline goes to $4 per gallon (readers from outside the U.S. may laugh bitterly here, but this is a heck of a shock to the pocketbook, even if it is a tiny fraction of European or Japanese prices).
“It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock,” David Rosenberg of Gluskin Sheff wrote in a note to clients.
“Because oil demand is relatively inelastic over the near term, this price shock is going to cut into real global economic growth and the question is by how much,” Rosenberg writes, before bringing up a real concern, a U.S. debt and political situation where further stimulus is highly unlikely.
“In the past, we would see governments trying to cushion the blow but with the public sector nearly everywhere grappling with sky-high fiscal deficits and debts and moving towards restraint, and with monetary policy already in uncharted accommodative waters, there is no leeway to provide any antidotes.”
To be sure, oil prices may well fall back if supplies are not interrupted and if concerns, especially about the potential for serious unrest in larger oil-producing states such as Saudi Arabia, prove baseless. While oil shocks in the recent past have usually led to recessions, they tended to be sustained rises in prices.
Earnings at Wal-Mart <WMT.N>, the massive retailer which looms large at the bottom end of U.S. retailing, tells a story not of recovery but continued hard times, conditions which are tough to square with recent risk market ebullience. Revenues were weak and the company noted a growing trend of customers paying for goods in the U.S. with government assistance, a half a percentage point rise in just three months.
Wal-Mart shoppers will feel every penny increase in the price of gas keenly, and are going to be very unwilling, or unable, to accept further price rises driven by commodity inflation.
This could easily undermine company profits. While companies report rising prices on the things they buy, prices on the things they sell are not keeping pace, presumably because they find it difficult to raise prices without driving hard-hit customers away.
Significantly, regional grocery store chain Wegman’s announced on Wednesday a price freeze on 40 basic necessities for the year, saying they will absorb $350 to $400 in price increases themselves for a family of four over the next nine months. That is the kind of thing which hits margins, and not just at grocery stores.
Meanwhile, the political situation in the U.S. is not going to be sending any shoppers running for the stores. A bitter dispute in Wisconsin over public sector workers’ pay, benefits and collective bargaining rights will likely give many workers, and not just in the public sector, the idea that what they thought was theirs may be taken away. Disputes in Washington over budget cuts will only serve to reinforce the sense that the ratio of transfers to disposable income is headed down ultimately, recovery or not.
So, what might the Federal Reserve do? If the oil price hike is sustained but price rises do not feed through to wage pressure, they will keep rates at rock-bottom and leave their options open over quantitative easing.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: firstname.lastname@example.org)