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How OPEC controls the Fed’s policy makers

Low oil prices are keeping a lid on inflation and preventing central bankers from raising interest rates


"You may not control all the events that happen to you, but you can decide not to be reduced by them." — Maya Angelou

A persistent issue faced by the U.S. Federal Reserve and central banks in other developed economies is the current rate of inflation and inflation expectations.

We can argue from here until tomorrow about whether actual inflation is higher or lower than the official rate. For policy makers, that is a moot point. Global markets have punished reflation trades for the better part of three years despite trillions of dollars in stimulus.

That stimulus has not been enough to prompt sustainable wage inflation and stronger demand, which could raise prices for goods and services more broadly. For the most part, consumers have been resilient but not an enormous driver of economic activity in a way that’s commensurate with central bank money printing.

The Fed will find it hard to raise rates unless inflation sustainably increases, reigniting the bull market and putting a lid on violent stock market gyrations.

Despite what on the surface appears to be a healthy environment for risk assets, the performance of utilities and Treasuries suggests the underlying dynamics of the marketplace are fragile. Why do I mention utilities and Treasuries? Because as shown in the summary of our award-winning papers (click here to download), those areas tend to outperform in advance of heightened stock market volatility and corrections. That’s why they’re important components used in the management of our alternative ATAC Inflation Rotation Fund ATACX, +0.00%

Utilities and Treasuries tended to be leading indicators of stock market volatility, and in turn tended to do well when a deflation pulse beats beneath the market's surface. Inflation expectations being as low as they are confirm this.

For utilities and Treasuries to underperform, that probably needs to reverse itself. This brings us to the crux of where we are in the cycle. The Fed will find it hard to raise rates unless inflation sustainably increases, reigniting the bull market and putting a lid on violent stock market gyrations.

What would cause that? Take a look, below, at the price ratio of the iShares Barclays TIPS Bond Fund ETF TIP, -0.27% relative to the iShares Barclays 3-7 Year Treasury Bond ETF IEI, -0.06% in blue. A rising price ratio means the numerator/TIP is outperforming the denominator/IEI. Against that is the price of the United States Oil Fund LP USO, +0.59% in black. Note that as the TIP/IEI ratio trends higher (a sign of rising inflation expectations), so too does oil. As those inflation expectations fall, oil falls.

It should make sense that oil, as a source of cost-push inflation, can be a major driver of the TIP/IEI ratio and, by extension, broad market inflation expectations. For Fed policy makers to raise rates, their last excuse (inflation) needs to go away as a reason not to hike. That means the price of oil is essentially a key decision maker in monetary policy.

Guess who, at the margin, is preventing oil from rising? It's OPEC, and as recent headlines indicate, those countries have kept oil production at multi-year highs despite slowing global demand. As OPEC continues to keep prices contained in oil, inflation expectations will have a hard time rising. For the Fed, that means lower rates for longer (or perhaps forever).

Want to know when SuperYellen and the League of Extraordinary Bankers will raise rates? Watch oil and pay attention to the marginal suppliers. The Fed no longer controls monetary policy. OPEC does.

As of Oct. 15, 2015, the fund didn’t hold any of the following securities: TIP, IEI, USO. The ATAC Inflation Rotation Fund is distributed by Quasar Distributors LLC.

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