Retreat of oil prices from their post-Labor Day surge above $35 per barrel should help neutralize the major risk factor in an otherwise largely positive setting for U.S. markets. To be sure, with the OPEC cartel and its unpredictable political motivations and rivalries now the dominant player in the international petroleum market, exogenous risk attributable to oil-price uncertainty is by no means eliminated. The pull-back from this morning’s +2% gains on the NASDAQ composite, in fact, mirrored the reversal of an early price decline in the crude futures pits, with the October contract closing at $34.50, up nearly $.70. Nevertheless, pricing indications within the oil market itself suggest that at least a near-term peak has probably been seen (i.e., longer-dated crude futures trading in backwardation relative to spot prices). Moreover, monetary relationships that have long characterized the oil price environment indicate current prices remain well in excess of longer-term equilibrium levels. With gold prices trading in a range in the low $270s, the historic ratio of 15-20 crude barrels per ounce of gold implies the oil price eventually falling back toward, or below, $20.  

For the first time since January the long bond yesterday closed at a yield, 5.73%, that was not inverted relative to all shorter maturities on the yield curve, with the10-year note finishing a basis point lower at 5.72%. The 10-year has been feeding off the same forces that have been pushing yields lower at the short end of the spectrum: expectations of a directional shift in monetary policy. The 2-year note is now positioned some 40 basis points below the 6.5% funds rate and, at below 30 basis points, the 30/2 curve is now at its flattest point since March, steepening by about half since mid-August. As noted here recently, with the 30-year having rallied to a range around 5.7%, further upside for the long bond was likely to be limited without some signal confirming the still-embryonic easing expectations (“Late-Summer Notes,” Aug. 31, 2000). The current curve steepening (i.e., unwinding of the inversion) can be viewed mostly as a process of catch-up for shorter maturities, consistent with growing market acceptance that the Fed’s next is more likely to be an ease than another tightening. Indeed, euro-dollar futures are now pricing for a possible rate-cut by early next year, although at this point it’s still a less-than-even-odds bet.

The fact that the recent curve-steepening has primarily seen shorter-term yields moving lower to close the gap with long-term issues, rather than vice-versa, is itself a reflection of the absence of inflation risk and should register at least marginally with the central bank. The current zero inflation environment is maintaining attractive real value even in nominal yields that are low by historical standards. The comments this week of Dallas Fed President Robert McTeer, the system’s only self-proclaimed supply-sider, indicate that he is one policymaker who understands these market signals. “Once we get over the energy hump, I wouldn’t be surprised if inflation declines and interest rates are going to come down,” McTeer told the Wall Street Journal. “The federal funds rate probably won’t lead” yields lower, McTeer said, but “eventually will follow.”   

Seen in this context, today’s sharp sell-off in longer-dated issues, the 30-year yield rising above 5.80%, appears to reflect short-term trading exigencies rather than any intensification of risk factors at the long end of the curve. “Disinversion” of the 30/10 spread, apparently, caught off guard a number of traders and forced liquidation of their large speculative positions designed to capitalize on the inversion. If that is the case, today’s yields present a buying opportunity, although the short-run upside probably remains limited to a region around 5.7%.

As McTeer suggested, the “energy hump” will remain a short-run obstacle. For one thing, the Fed is unlikely to seriously entertain the possibility of rate cuts in the face of the oil price bump feeding through the official inflation statistics over the next month or so. Nor, by the way, should they. Contrary to conventional wisdom, rising oil prices do not foreshadow rising inflation, except in the narrow sense of registering as “inflation” in the CPI and PPI data. In the absence of easy monetary policy allowing producers to pass rising energy prices to consumers, higher prices increase the cost of production, reduce profit margins and are thus contractionary. With gold more than $10 below its one-year moving average and the dollar’s foreign exchange value continuing to hit multi-year highs, monetary policy is anything but “easy.” The potential for inflationary error arises, however, if the Fed, responding to indications of economic slowing, eases policy to accommodate the higher cost of energy. That was one of the catalysts of the 1970s monetary conflagration, with the cheaper dollar setting off a chain reaction of oil producers pushing prices still higher to compensate for the lost purchasing power of their dollar revenues. Fortunately, the high-tech U.S. economy is considerably less petroleum-dependent, and thus less sensitive to the policy risks arising from rising oil prices, than it was even fairly recently. Economists at the Dallas Fed, noting that the “amount of energy consumed in each dollar of GDP has declined,” estimate that the economy is one-third as sensitive to oil price changes as it was in the early 1980s, and about half as sensitive as it was in the early 1970s.