Making Sense of Rising Prices, Oil's Surge, Credit Markets and War

As the war in Ukraine rages on, uncertainty about the economic fallout is growing. Surging gas prices threaten to curb household spending, a fresh set of supply chain problems could hamper corporate earnings, concerns over funding markets are growing. Here, I'll tackle some common questions I'm getting from readers and clients about what comes next for the economy.

Will spiking oil cause a recession?

There is an oft-repeated Wall Street aphorism that when oil prices rise 100% in a year, a recession always follows. We've hit that magic mark recently, as oil was a bit under $60 March of last year and is now around $120. The reality is that oil's relationship to the overall economy isn't that simple. First, the 100% threshold has only been breached one other time in the last 40 years. That was in 2008, and while a recession technically did follow, that period was about a housing bubble, not really oil prices.

That aside, clearly surging gasoline prices will matter for consumer spending. But the relationship between gas prices and all other spending is complicated. The correlation between retail sales excluding gas stations and the average price of gas has been historically weak. I ran the rolling three month change in each since 1990 and the correlation was 0.16, suggesting almost no relationship between the two.

Part of the problem is that gas demand tends to rise at the same time consumer spending more generally is rising. To get a cleaner look at what spiking gas prices can do to general consumption, I isolated periods where gas prices rose at least 10% in a three month period. This happened 30 times since 1990, so it is a decent sample. Of those, 10 times other retail spending slowed from the prior three months. The other 20 periods, spending increased. Of the 10 times where spending fell, only three times was spending still slower six months later.

What we might take away from this data is that when gas prices rise over a short period, consumers simply dip into savings or borrow to keep their other spending consistent. The same could happen now, as consumer savings levels are currently elevated.

If the cost to fill up remains high for a while, it appears that consumers find ways to adjust. I also looked at how consumer spending held up a year after the initial spike. About 60% of the time gas prices were higher still even a year later, but in all but one of those periods, other retail spending had risen over that year.

This isn't to say that higher gas prices are irrelevant. Rather that as long as household income continues to grow, U.S. consumers are generally able to adjust to higher prices at the pump. Given the strength of the labor market generally, and robust wage growth specifically, consumption should remain solid even in the face of higher gas prices.

But is Europe a different story?

The electricity generation mix in Europe is much more directly impacted, however, especially if natural gas stops flowing from Russia. Hence, the impact isn't just gas prices, but also utility bills there. Electricity prices were already soaring in Europe and the U.K. prior to the invasion of Ukraine. Prices per megawatt hour more than doubled in Germany, France, the U.K. and elsewhere in calendar 2021, and they may go much higher in the coming months.

Exactly what the effect of this will be is hard to know, but it means that a much bigger part of European household budgets are getting squeezed. For example, in Germany the combination of motor fuel and household energy makes up about 10.3% of total budgets. Gasoline and home fuels (like heating oil and propane) only make up about 4% of U.S. household spending. 

European household income growth was also weaker than the U.S. going into this period. So the combination of more middling income growth, much higher changes in overall energy prices, and a larger wallet share to energy, all means this will have a much larger real economy impact in Europe. Indeed there is chatter now that Europe may already be in recession now.

Are the credit markets showing stress?

All in all, the credit markets are functioning pretty well. Interbank funding markets have shown a little stress, with London Inter-Bank Offered Rate, orLIBOR, rising much more than central bank's rate, which is typically a sign of banks hoarding cash. Funding levels related to the U.S. dollar, such as cross-currency swap spreads, have moved a little as well. This is enough to suggest that many cross-border banks are looking to load up on dollars. In my view, none of these spread moves suggest true banking stress, but more banks raising their level of concern and therefore looking to hold more reserves and especially more USD reserves. Even there, we aren't seeing signs of true stress. For example, the Fed's USD swap lines with other central banks remain virtually untapped. There's elevated demand for dollars, but so far the demand is manageable.

Meanwhile, the actual credit markets are functioning quite well, all things considered. On Wednesday Discovery (DISCA) and AT&T (T) brought a massive corporate bond deal related to Discovery's acquisition of Warner Media. The deal will be about $30 billion, making it one of the largest corporate bond deals to date. There were at least $107 billion in orders. This follows a very heavy new corporate issuance level last week, including several investment-grade and high-yield bonds.

So, while credit spreads are wider, the market is functioning. Even with wider spreads and somewhat higher Treasury yields, overall the cost of funds for companies is still attractive, and debts that need to be rolled over can be rolled over easily.

Can the Fed respond to any weakness?

So far I've mostly had good news to report, but here's a word of caution: The Fed probably can't come to the rescue. Inflation is such a large problem that the Fed is probably intent on tightening policy almost no matter what. That doesn't mean the Fed won't support market liquidity should credit markets freeze up. But unless something like that happens, the Fed is probably going to remain on a tightening path.

Of course if there were real economy weakness, it is likely that consumer spending would cool and inflation would subside. In which case, the Fed could certainly stop hiking. But I think it is fair to say that the Fed isn't going to ride to the rescue of risk markets until there is a much more palatable threat of a recession.

This also means that Treasury yields can only fall so far. Last week the 10-year Treasury hit 1.70%, but with rate hikes on the horizon, it is going to be very hard for yields to fall a lot more than that. The risk/reward in interest rates remains skewed to higher yields.

Is the status quo unsustainable?

Last point I want to make is that current conditions can't remain the same indefinitely. That goes for the war in Ukraine itself, which could last for months but probably can't last for years. And geopolitics can move suddenly, either because of some large surprise, like a regime change, or a smaller one, like a break in negotiations.

The events in Ukraine have created extreme conditions in various markets, which means those markets are vulnerable to sudden changes. We see that in trading on Wednesday morning, where even mild signs of a possible ceasefire sent oil and wheat prices plunging and stock prices soaring.

I bring this up not because I have any insight about a resolution in Ukraine. I only know what I read -- just the same as everyone else. What I do know is markets, and I know that in highly volatile situations, people can fall for extrapolating current conditions out too far. Now is a time to be especially humble about what you know and what you don't know.

At the time of publication, Graff was short 5-year, 10-year and Ultra 10-year Treasury futures.