Here's How The Rate Hike Will Affect Oil And Inflation

How much are stocks worth without being propped up (as much) by the US Federal Reserve? Investors prepared to find out Wednesday morning.

The one nearly sure thing following the Fed announcement at 2 PM Eastern Time US is volatility, quite possibly for some time. It’s not only stock investors and those who are directly affected by credit who will have to adjust to a rate increase. The oil market will also face a reckoning.

And further pressure on oil prices may in turn affect inflation. And inflation, of course, is one of the major factors that will determine whether an interest rate increase today will be followed by further tightening in 2016. It’s the circle of life.

The Standard & Poor’s 500 Index has risen over 200 percent since March 2009, the low point of the Great Recession and the trigger for the Fed’s decision to lower borrowing costs to essentially zero. It has been seven years of zero interest rates, an unprecedented circumstance in modern history.

Many have commented that the stock market’s series of multi-year rallies, interrupted by a Flash Crash in 2010 and other corrections that were not so flashy, was essentially an engineered bubble, fueled by a vast supply of free money printed by the Fed. Now that supply is smaller and cheap, rather than free, which means the bull market will have to rise on its own.

To do that, the US economy must continue to get stronger and companies have to show strong earnings that come from actually selling valuable goods and services, not from accounting tricks and layoffs that reduce payroll costs. Over the long, long term, the US stock market does go up, but in the next few months it will face volatility and the ongoing turmoil in junk bonds and crude oil.

The Chicago Board Options Exchange Volatility Index (VIX) is already at levels higher than at the start of previous Fed liftoffs. Since 2011 or so, the increased dominance of algorithmic trading has meant that price moves that used to be considered big at 10 or 20 points in the S&P 500 are now routine, with 30 and 40-point moves now a routine occurrence.

Crude oil presents the interesting challenge to bullish investors, not just energy traders. Seven years of zero-interest money made it possible for shale oil and gas drillers to expand their operations and take on expensive, risky ventures. They did so expecting to get $80 or $100 a barrel as their payoff. After today’s Energy Department report showed a continued and growing glut in global supplies, WTI crude dropped to new multi-year lows.

Higher interest rates mean that energy producers with large debts and even lower revenues will have trouble staying solvent. Those that are publicly traded are already seeing investors fleeing and their stocks will only drop if the rate hike affects their ability to get short-term credit to cover costs.

A rate hike will also likely strengthen an already strong dollar. Since crude oil is priced in dollars worldwide, this would just add more pressure, as the strengthening dollar has already done.

Cheap oil prices and weak job growth in the energy sector will make inflation less likely to go up and may even increase the 5 percent unemployment rate. Given that the Fed’s decision to raise rates hinges on the expectation of low unemployment and increasing inflation in 2016 and beyond, it will be ironic, but not inexplicable if this rate hike—whenever it happens—ends up interfering with the very processes that justified doing it in the first place. Now that would be a strange vicious circle.

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