Remember the days when oil prices were just something you needed to worry about whenever you stopped at a petrol station? These days, the sad reality is that the impact goes well beyond the fuel pump. Whether it be your next holiday or even your weekly grocery run, oil prices have a way of showing up where you least expect them to.
Just think about it this way. When oil prices surge higher, airlines will then have to pay more for jet fuel. And if those costs keep climbing, some of that could eventually find its way into your airfare.
It is the same for groceries as well. Higher transportation costs mean businesses will need to spend more in order to get products onto supermarket shelves. And guess who has to end up footing the bill in this instance? Yep, you and me. And that is where the inflation story comes into the picture.
But what happens when people start expecting prices to keep rising?
Well, that is where central banks like the Fed have a problem on their hands. Now, one of their main tasks is to keep inflation under control. So instead of cutting interest rates to support the economy, they might have to keep them “higher for longer” instead – especially if rising energy costs feed into broader inflation expectations. And that in turn will make things rather uncomfortable for the bond market.
Let’s keep things simple for this one. When inflation risks rise, investors may demand higher yields to compensate for the loss of purchasing power. And when you add in expectations of tighter monetary policy into the mix, then suddenly bond yields can climb even further.
That covers the bond market, but why should stock traders care?
Well, the simple narrative is that higher yields make borrowing that much more expensive for businesses. They also make government bonds more attractive relative to stocks, especially expensive technology stocks whose valuations depend heavily on future earnings.
Meanwhile, higher US yields can also lend support to the dollar as investors look for better returns on dollar-denominated assets.
Now, can you start to see how it all comes together?
Of course, markets aren’t always quite so predictable in reality. Just take the scenario where an oil price shock gets bad enough to spark recession fears, then bond yields could actually fall instead as investors start worrying more about growth rather than inflation.
So the next time you see oil prices making the headlines, don’t just think about how much more you’ll be paying at the pump. Somewhere along the way, that same price shock could also be shaking up bond yields, the dollar and Wall Street.
This article was written by Justin Low at investinglive.com.