The US Federal Reserve looks on course to raise the federal funds lending rate at its upcoming May meeting, which would push it to a level not seen since 2007. The expected bump raise in the rate has been a factor in the oil price retreat in the past week, as the market has priced in a stronger dollar and downside pressure on oil. The excess money supply in the US market still holds some upside potential for oil prices, but any signal of a “higher for longer” outlook from the Fed on interest rates holds further downside risk for oil prices in the short term.

The May meeting

  • The consensus for the Fed’s May meeting is that the US central bank will do what the market is pricing in and hike its federal funds lending rate by 25 basis points, thereby pushing it above a 5% threshold not seen since 2007.
  • Inflation in the US has proven to be not so transitory and more than sticky by many measures. The core Consumer Price Index (CPI) in the US jumped 0.4% in March and 5.6% year-on-year. Fed chairman Jerome Powell has said he will make policy decisions based on data, and the data still signals stickiness and, thus, more rate hikes.
  • There is still a significant amount of excess money supply in the US economy that needs to be fully absorbed in goods and services, which means that prices will still be pushed higher and that the Fed’s medicine may need to be administered at a higher dose for a longer duration.
  • Stability of the banking system is a primary duty of any central bank. By raising interest rates, the Fed would risk putting the commercial banking sector under further strain, with the potential of more regional banks collapsing.
  • The US Department of the Treasury has not yet provided assurance that it will swoop in and insure distressed financial institutions, which has contributed to the overall bearish financial market sentiment – of which oil, as a highly liquid and tradable asset, is in the crosshairs.

What the fight against inflation means for oil

  • The price of oil is likely now very low on the list of considerations for the Fed in setting its monetary policy.
  • Covid-19 pandemic-era stimulus and excess money supply helped propel oil prices to new highs in 2022, and since excess money supply is not being fully absorbed by the market, this means there could still be some limited near-term upside for prices to rise – oil included.
  • However, the initial inflation boost to oil prices is now being offset by more hawkish monetary policy and the perception that a less liquid market will crimp economic growth and possibly induce recession. Too high interest rates were in part blamed for the lead-up to the US banking collapse that began to unfold from 2007. The combination of high interest rates and a tight credit landscape increases the likelihood of a recession, which would decrease incremental oil demand.
  • The fight against inflation and the extreme strength it has brought to the US dollar puts downside pressure on oil prices as the commodity becomes more expensive for importing countries with significantly weaker domestic currencies versus the dollar.
  • The focus now is on the US dollar and Fed policy, but a bigger monetary risk lurks in mainland China, which could decide to ‘loosen’ its money supply by deflating its currency in a bid to stimulate its export-driven economy, which could prove deflationary overall for global economic growth. China can also put deflationary pressure on its economy through top-down industry regulation, which has been applied to the real estate sector in particular in the past few years.
  • The market has correctly priced in the Fed’s moves in eight out of the last nine meetings (Figure 1), however the relationship between Brent front-month futures and the Fed’s moves is quite inconsistent but skewed to the downside in terms of sensitivity and biased to the upside in terms of frequency.

May seasonality

  • The current pullback in oil prices – below $80 per barrel of Brent, which has happened a handful of times since November 2022 – is wrapped into recession fears as credit conditions in the US and many other economies tighten, and uncertainty looms over the pace of Chinese demand recovery.
  • The US economy slowing to 1.1% annualized first quarter 2023 growth versus 2.6% in the previous quarter on an annualized basis is a potential but not fully confirmed harbinger that higher borrowing costs and rising prices may stall economic growth. China targeting an “about” 5% growth target for its GDP, in a serious of continuous downwards revisions, also puts into question how much of a bull China can deliver for economic growth and oil prices.
  • The relationship between gross domestic product (GDP) growth and oil demand is strongly correlated but has slightly decoupled following the pandemic, along with shifts in consumer habits and the high oil price environment, which in normal market conditions leads to negative demand elasticity.
  • May will be a noisy month in terms of both macro data and fundamentals seasonality. May is generally a shoulder season that sees subdued demand – both from refineries undergoing maintenance and from consumers who are waiting until the Northern Hemisphere summer to travel – so weak demand signals now do not necessarily mean weak prices into the high demand summer season.
  • May will also be the month we better understand how much of the 1.1 million barrels per day (bpd) of its voluntary cuts OPEC+ will deliver, as well as how much Russian crude and diesel continues to flood the market and fill up inventories.