Breaking Down Breakeven Rates Part 4
Making matters worse, the logical conclusion of the “boom times” narrative is that policymakers need to start being wary of inflation posing a threat again. Central bankers must therefore start tuning monetary policy to take into consideration the dangers of inflation becoming rampant and raging out of control.
Firstly, central bank and government action has not led to any sort of “good” inflation, and as long as they continue to vastly overestimate the degree of control they have over the financial system and economy, neither will be able to exert any control at all.
Secondly, and here the narrative’s misunderstanding of the inflation situation comes back to haunt it, how is monetary/fiscal policy supposed to help combat higher inflation predominantly caused by supply factors?
Ironically, if the narrative has its way, it could lead to even higher inflation! This could occur as higher rates kick off the domino effect of higher debt costs for heavily indebted shale producers, leading to another spike in shale bankruptcies and hence even lower oil and gas extraction in the US. The result? Even higher oil prices.
Granted, the chain of events discussed above is long and very linear, and many things can happen in between that changes the outcome. But, if events play out as written above, stagflation becomes a real possibility.
Also, consider that the spike in UST Note (10y) and Bond (30y) yields due to traders/investors “pricing in” inflation will already have raised funding costs for debt issuers, with shale producers no exception. The Fed may be just as irrelevant in this as they are with trying to generate economic growth with QE.
From a broader perspective, it isn’t just oil prices contributing to the “boom times” euphoria. Copper prices, like oil squeezed higher due to supply issues, global equities trading at or near record highs, and now higher Treasury yields pulling up interest rates all over the world are all adding fuel to the narrative.
But, higher breakeven rates do not necessarily mean higher inflation. The chart shows the 5 year breakeven rate diverging with CPI, both having bounced back together following the initial Covid shock.
While this divergence may or may not amount to anything significant in markets, it does make one wonder if maybe, just maybe, too many assumptions have been made with too little thought as to what is actually going on behind the rally in breakeven rates.
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