Crude oil - is inflation good for black gold? Why? Why not?

No one was naïve enough to expect an agreement on the US debt ceiling yesterday, when US President Joe Biden met Kevin McCarthy. But some hoped that there could be at least an extension of the debt ceiling to September, until the end of the current fiscal year, which would allow both parties to engage in deeper talks about what to do with the 2024 budget and the debt ceiling altogether.  

But no.  

Biden and McCarthy couldn't agree on much, but they agreed that there would be no extension to the debt ceiling.  

Biden doesn't want to push US to default – that would be a disaster – but he can't agree on severe budget cuts either. His electors would be too angry. The leaders will meet again on Friday. Debt ceiling discussions will certainly extend toward the last minute, and the chances are that we see a last-minute goal to avert a possible US government default. Until then, uncertainty will loom, and risk appetite will likely remain limited. 

US treasuries remain under a decent selling pressure especially on the short end of the yield curve as investors dump US short term papers due to the rising US default risk. The US 1-month bill yields around 5.60%, the US 2-year yield advanced past the 4% mark, the S&P500 slid 0.46%.  

The US dollar popped higher on Tuesday, boosted by the rising US yields, but gold is certainly a better alternative for hedging a potential US default risk, as a potential default would clearly put pressure on growth prospects, Federal Reserve (Fed) expectations and weigh on the dollar as a result.  

Gold is a better choice for hedging against rising tensions with China, as well, as Italian PM Meloni told McCarthy yesterday that she wants to exit the Chinese Belt and Road Initiative. The price of an ounce trades around the $2030 this morning and could find the force to test the $2080 offers to the upside and clear them. Upside potential extends to $2200 per ounce.  

Similarly, the long end of the US yield curve could be an interesting refuge for risk averse investors, given that a potential US default would immediately send the Fed rate cut expectations to the moon, and would apply a decent pressure on the long end of the yield curve. US 10-year papers now yield around 3.50%. In case of a problem, we could see them fall all the way to 2.80/3%.  

Read next: China's trade data show Chinese exports increased faster than expected in April| FXMAG.COM

Looking at Bitcoin, it doesn't seem to offer any relief to actual stress. The price of a coin is down below the $28K mark, and could remain under pressure, parallel to sentiment in tech stocks. 

And US inflation? 

The US will reveal a much-important update to its CPI today, and the data could also shake sentiment at today's trading session.  

Core inflation is expected to have slightly eased from 5.6% to 5.5% in April, headline inflation is seen steady at 5%, while we might see an uptick in monthly headline figure, to 0.4% from 0.1% printed a month earlier due to the spike in energy prices after OPEC cut production last month.  

In all cases, whatever we see in US CPI report today, it's important to note that inflation expectations are falling. The NFIB survey showed yesterday that there is a severe decline in the number of small companies that are expected to raise prices. That should, at some point, play in favour of slowing price pressures. 

For today, a CPI report in line with expectations will keep focus on debt ceiling, but a report that diverges from expectations could give an extra spin to market pricing. A softer-than-expected CPI report should further fuel the Fed rate cut expectations into this fall and relieve a part of the positive pressure on US yields, whereas a stronger-than-expected read will hardly boost any hawkish bets at this stage. Concerns regarding the US regional banks and the unresolved debt ceiling issue hint that the Fed can no longer walk alone and hike rates. Therefore, a stronger inflation report would only hint at lower real returns on US denominated assets. The latter would weigh on the US dollar, help the EURUSD rebound past 1.10, and keep Cable upbeat near a long-term trend negative trend top.  

Is inflation good for oil? 

One frequent question is how would oil react to inflation data. Is inflation good for oil prices, or is it bad?  

Some argue that inflation is good for oil, because oil tends to perform well in periods of high inflation. This is true. But if oil performs better during periods of high inflation, it could be because higher oil causes higher inflation.  

And the opposite – higher inflation is good for oil – may not be true.  

There are two reasonings. 

1. If inflation is higher because of strong growth and robust demand, a period of high inflation could be supportive of oil.  
2. But today, we are mostly talking about a looming recession and tightening monetary conditions. In this context, higher inflation may not translate into better appetite for oil, if a scary inflation number fuels the hawkish Fed expectations. 

The barrel of US crude is trading around $73pb this morning. The $75/76 range, which shelters the 50, 100-DMA, will likely act as a solid resistance to price advances.  

In the medium run however, crude oil outlook remains neutral to positive, as tighter supply from OPEC and rising demand, especially due to the rebound in travel demand, should continue giving support to the bulls. But whether we would see levels above $80pb sustainably is yet to be seen.