The three-point rout that lifted the long bond yield by more than 20 basis points to 5.95% the past three sessions bears a close correspondence with the latest bounce higher in crude oil prices to nearly $37 per barrel, but not for the widely cited reasons. Some maintain the relationship is as straightforward as it looks – higher oil prices mean higher inflation and thus lower bond prices. Others say the oil-price surge will give the Fed the excuse it needs to raise rates again, and bond yields are rising as a result.  Neither argument, however, is consistent with presently observable conditions. The tripling of oil prices over the past 18 months has yet to spillover in the more sensitive core inflation indices, and is unlikely to do so spontaneously with gold holding in tight ranges just above $270 per ounce and the dollar continuing to strengthen against foreign exchange. Were the oil-price spike upping the odds on another Fed rate hike, meanwhile, shorter-term yields would be rising, not falling. Indeed, readings from the interest rate futures markets suggest a rising chance of a rate cut, not a hike, early next year.

That, in fact, appears to get at the principal explanation for the bond market’s sudden setback: a rising risk premium attributable to a convergence of forces that could compel the Fed to enter an easing cycle at precisely the wrong time. As pointed out here last week, the inflationary implications of a rising price of oil – a non-inflationary change in relative prices – arise only from risk of the Fed accommodating the growth-retarding effect of the higher price with easy money. The central bank would then be moving to provide liquidity at a faster pace against a slowdown-induced decline in money demand, potentially fostering a liquidity glut. The supposition that this represents a relevant risk gained added credence with last Friday’s release of August industrial production data showing the second consecutive monthly contraction in the “Old Economy” precincts of the manufacturing sector. That can be laid at the feet of both the Fed’s year-long growth jihad raising the funds rate by 175 basis points, as well as the tax effect of rising oil prices.              

This is the dilemma Alan Greenspan has visited upon himself by abandoning his stable-money, price-rule principles and getting co-opted by the FOMC’s output-gap consensus. The flip side of the fallacious formula compelling the Fed to tighten in the face of rapid real growth, of course, demands ease in response to indications of significant deceleration. Measured against the only performance criterion for the Fed that matters – safeguarding the currency’s purchasing power – the potential for error arising from this policy regimen is vast.  If nothing else, though, Greenspan has had unusual luck on his side throughout his tenure, and this episode will probably be no different.  For one thing, although attempting to call an oil-price top has been hazardous business, there is not much question that the margin for additional upside is dwarfed by the potential downside. Should oil prices break from current levels and settle in a range even as high as $30 per barrel, the potential inflationary dangers of a corresponding Fed ease would be commensurately reduced.

Moreover, there is yet little, if any, indication of money demand being hindered in this era of extraordinarily dynamic wealth creation and productivity-boosting technological innovation. Indeed, all indications are that the Fed’s misguided exercise in growth restraint has extracted a significantly heavier price from the smokestack industries than it has from the high-tech, New Economy vanguard driving the expansion. The backup in bonds seen to date, then, reflects the somewhat higher risk of an unexpected increase in future inflation, rather than a rise in actual inflation expectations. At this point, that risk – while not inconsequential – still seems well contained. Absent any other indications of a threat to dollar purchasing power, the real value in nominal yields just below 6% remains highly attractive, as suggested by today’s half-point bounce off yesterday’s lows.