Inflation returns: oil price spike lifts prospect of higher for longer

Just when we thought inflation was peaking and central banks in the West could think about pausing interest rate hikes and even consider cutting rates, along came Opec + on Sunday evening and cut their production. The total cuts announced are approx.1.16 million barrels of crude per day, which triggered an immediate spike in the Brent crude oil price, it rose 5% on Monday to more than $85 per barrel, and it is expected to continue its climb on Tuesday, with futures markets expecting prices to rise by another 0.5%. While Opec cutting production is nothing new, the economic and political ramifications could be enormous, and it now raises the spectre of a period of stagflation – when growth slows, and inflation remains high.

Higher for longer oil price

In recent months, Opec + had made production cuts equivalent to 3.7% of global demand, which leads to the question, why cut now? The price of Brent crude had fallen back towards $70 per barrel in recent weeks, but it had been climbing to just below $80 before the production cut. Now, because of the supply cut, Goldman Sachs analysts are expecting the price of a barrel of Brent crude oil to rise to $95 by the end of this year, and to $100 by the end of 2024. Perhaps Opec + were making a premptive cut ahead of any global recession in the coming quarters. Usually, Opec + is behind the curve when it comes to these things, think the large supply cut after the onset of the pandemic and the crash in the oil price. However, this move is interesting because it is an assertive decision, and a clear sign to the world that Opec+ sets the price of oil, regardless of the economic conditions in the West. Hydrocarbons and oil are also an important part of the shift to net zero, and since that shift takes time, then we remain at the mercy of Opec + for the foreseeable future.

The market impact of a higher oil price

The economic ramifications of the rising oil price were clear on Monday: a 5% boost in the price of Brent crude oil led energy companies higher, with BP and Shell both rising approx. 4%. This helped to boost the FTSE 100, which was one of the best performing indices in Europe at the start of the week. Commodity currencies also fared well, with the Aussie dollar, the Kiwi dollar and the Canadian dollar topping the G10 FX space. In AU, the RBA struck a hawkish tone during its meeting, even if it kept rates unchanged. It said that some future tightening of monetary policy will be necessary to bring inflation under control, and that the pause in rate hikes this month is temporary to allow the RBA board time to assess the impact of 360 basis points of cumulative tightening in recent months. The RBA mentioned that in terms of future rate rises, it will be dependent on global trends for inflation and growth. Thus, the recent surge in the oil price will be fresh in the minds of all central bankers as they set policy in the coming weeks and months. AUD/USD hasn’t benefitted too much from the hawkish tone from the RBA, and it is trading down 0.4%, at $0.6760, reversing some of the gains made on Monday.

Re-pricing of US rate hikes

Another impact of the Opec + production cut was a repricing around the Fed’s next move. The market is now pricing in a 56% chance of a 25-basis point rate increase when the Fed next meets on 3rd May. This is higher than the 48% chance that was priced in last week and suggests that the market now expects the Fed to continue with its rate hiking cycle. Thus, the Opec + cut makes the prospect of a Fed pivot less likely, however, this may not dent risk sentiment for too long, as the market is still expecting some aggressive rate cuts from the Fed in the second half of the year. According to the Fed Funds Futures market, there is a 33% probability that interest rates in the US will be 4-4.25% by January 2024.

The political reason behind the Opec production cut

There is also a political ramification of the production cut. Interestingly, Saudi Arabia also agreed to cut production by 500,000 barrels per day. This move could be a sign that Saudi’s MBS is not happy with President Joe Biden and his failure to refill the US’s Strategic Petroleum Reserve with Saudi oil. Thus, if the White House wants to reduce the chances of stagflation and all the ramifications that comes with it, then they may want to work out a deal with MBS, and start refilling the SPR.

The market impact 

Elsewhere, in the FX space, GBP/USD is back at its highest level since January, after breaking above the $1.24 level, cable has gained more than 2% so far this year, even if it hasn’t always moved in a straight line. GBP’s performance is better than EUR, and EUR/USD is up 1.9% YTD. After breaking above $1.09, EUR/USD is making hard work of life above this key level, and is currently easing back to $1.0907, suggesting that $1.0910 is a key resistance level to watch. Overall, the market will be looking at US Jolt Job openings data on Tuesday to see how tight the labour market is, alongside Eurozone producer prices. Service sector PMIs for March will also be watched closely on Wednesday. From a market perspective, the Opec production cut has reinvigorated the uptrend in the oil price, which could weigh on the Nasdaq, and ultimately boost the USD if it leads to greater expectation that the Fed will have to hike rates for longer than currently expected.