OPEC production cut sparks inflation outlook concerns

Could interest rates stay higher than current market expectations?

Tom Eckett

OPEC oil

Investors positioning for a peak in inflation were dealt a blow last weekend after the Organisation of Petroleum Exporting Countries (OPEC) made a surprise cut to oil production, a move that could have a significant inflationary impact on the global economy.

Oil prices surged as much as 8% on Monday on news OPEC and its allies plan to cut global oil production by one million barrels per day (bpd).

OPEC’s de factor leader Saudi Arabia will absorb the majority of the cuts as Washington came out strongly against the move from the cartel which had previously promised to keep oil supply steady.

The decision, which adds to the two million barrels the cartel originally agreed to cut in November 2022 until the end of this year, is expected to add to inflationary pressures at a time when central banks are walking a tightrope between financial stability and high inflation.

“The development comes as a blow for inflation, with expectations of inflation coming down partly balancing on the trajectory of the oil price,” Sophie Lund-Yates, lead equity analyst at Hargreaves Lansdown, said.

“Markets are aware that if the pressure continues, central banks will need to extend or strengthen their interest-rate hiking cycles, the expectations of which will need to be repriced.”

Her views were echoed by Ole Hansen, head of commodity strategy at Saxo Bank, who warned the Federal Reserve’s task of bringing inflation under control is now more difficult.

“It could bring in doubt market expectations for 50 basis points (bps) lower Fed funds rate by the end of the year,” Hansen added.

Investors, however, seem unfazed by the prospects of higher-than-expected inflation with the iShares $ TIPS UCITS ETF (IDTP) seeing $283m outflows over the past week, as at 3 April, according to data from ETFLogic.

Added to this, markets are currently pricing in a 92.2% probability the Fed funds rate will be 50bps lower than current levels, according to the CME FedWatch Tool.

Forecasts of Fed rate cuts this year were supported by weaker-than-expected jobs data on Wednesday with payroll processor ADP announcing US private businesses created 145,000 jobs in March, lower than forecasts of 200,000.

However, with equity markets perfectly priced – as highlighted by the technical bull market the Nasdaq 100 entered last week – risks remain to the downside.

According to Peter Lowman, CIO at Investment Quorum, OPEC’s decision to cut supply is a boon for oil prices and energy stocks but could create an “uncomfortable” monetary policy backdrop for central banks.

“Oil prices are a significant factor in determining inflation, and any significant increase will create a further upwards lift,” he warned.

In this uncertain environment, adding duration to fixed income allocations is a risk, especially if inflation stays higher-for-longer, while the energy sector is an obvious winner.

“Charting a clear course through these choppy waters has been challenging,” Lowman added. “But our current asset allocation positioning has been fairly robust: it has a higher weighting towards global income, value and commodity exposure.”