Oil is Up Again But Inflation Bets Won't Follow. That's a Red Flag.

Crude oil is up again, but market inflation expectations have stopped tracking it. The last time that happened, a growth scare followed. Is another one ahead?

• Crude oil rose after Houthi attacks on Saudi Arabia and fresh strikes on tankers in the Strait of Hormuz
• University of Michigan consumer sentiment fell to the second-lowest reading in the survey’s history
• CPI, PPI, and retail sales data this week may test whether markets are overpricing 2027 Fed rate hikes

Crude oil started the week higher after Houthi forces struck Saudi Arabia, hitting the airport in Riyadh and causing casualties, while tankers came under fresh attack in the Strait of Hormuz. West Texas Intermediate (WTI) crude climbed toward the middle of its recent range, putting highs above $101 per barrel back in view if the move extends.

The reaction followed a familiar wartime script. Gold eased back from the top of its consolidation range as the oil pop revived inflation worries, though US bond markets were closed for a holiday. Stocks were soggy too. The S&P 500 edged lower, still pinned beneath its mid-August highs. The Nasdaq 100’s recent breakout looks increasingly like a false start after reports that Chinese chipmaker CXMT is developing server memory to rival South Korean products. That news sank South Korean shares, including SK Hynix and Samsung, and weighed on AI chip names more broadly.

Inflation expectations have stopped following oil

Beneath the surface, the bond market is sending a different signal. For most of this year, five- and 10-year breakeven inflation rates priced into Treasury bonds have moved with crude oil. The exceptions have been telling. When oil rebounded in July, breakevens did not join the move for about a month, as if pricier energy would not be enough to lift prices because demand in the underlying economy was weakening.

Stocks less insulated by tech, such as the small-cap Russell 2000, the Invesco S&P 500 Equal Weight ETF (RSP), and the ProShares S&P 500 Ex-Technology ETF (SPXT), looked soggy through July. Once the varnish of AI enthusiasm on the headline indexes is peeled away, the market’s sensitivity to growth and rates is still there. Now oil is bouncing again, and breakevens are pointedly not following.

Consumer data support that reading. The University of Michigan’s sentiment index fell to 46.3 in its preliminary October survey, below the 47.6 expected and second only to May’s record low. Its gauge of current conditions hit an all-time low. One-year inflation expectations jumped to 4.7%, the highest since May. Sentiment has tended to sink as those expectations rise since the Covid-19 pandemic. The Conference Board’s consumer confidence index recently fell to its weakest since 2014.

Meanwhile, the Atlanta Fed’s GDPNow model has slid to 3.6% for the third quarter, down from 5-6% in late July and early August. The level matters less than the direction, which has suggested that the latest economic data flow has carried negative implications for GDP growth.

Are markets overpricing 2027 rate hikes?

Rate hike bets have already cooled from their hawkish extremes. Two weeks ago, markets were convinced of a hike in October, entertained back-to-back moves that month and again in December, and priced three more increases for 2027. Fed funds futures now put the odds of no change in October at about 80%, and still treat a 25-basis-point (bps) hike in December as a lock.

That matches the Fed’s September projections. Traders and policy officials disagree about next year however. Markets fully price another hike by April and lean in favor of one more by June. The Fed sees rates peaking in 2026, leaving policymakers on the dovish side of the argument to the tune of 50bps.

Inflation trends lean toward the Fed’s perspective. The three-month annualized pace of the personal consumption expenditures (PCE) price index, the Fed’s preferred gauge, is already at the 2% target, and the smoother six-month rate has been easing since peaking in May. The Cleveland Fed’s nowcast points to higher headline inflation in the next two months, but the core trend, which sets aside much of the war-driven supply shock, looks to be pointed lower.

This week’s data will put that view to the test. The consumer price index (CPI) arrives Wednesday, with headline inflation expected to jump to 3.7% year-on-year from 3.4%. The core rate, which excludes food and energy, is seen edging up to 2.5% from 2.4%, while its monthly pace slows to 0.2% from 0.3%. Producer price index (PPI) figures follow Thursday, with headline and core monthly gains expected to quicken to 0.5% and 0.3%, respectively. The key question is whether demand-driven price pressure is fading beneath the cost push from the US-Iran war.

Retail sales will gauge consumers’ staying power. Receipts jumped 1.2% in the prior report, largely because shoppers paid more for fuel, since the data are not adjusted for inflation. A 0.3% rise is expected this time. Fed Chair Kevin Warsh will also speak at a fireside chat with the managing director of the International Monetary Fund (IMF).

If the week’s news-flow points to softening demand, especially for the core economy, the markets’ 2027 rate hike bets may start to look overcooked, leaving room for them to unwind. That may drive bonds and gold prices higher as the US dollar weakens. Wall Street might come under pressure too, although the pain may again be concentrated in parts of the market away from the AI buildout boom.

Ilya Spivak, tastylive Head of Global Macro, has over 15 years of experience in trading strategy. He specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak

For live daily programming, market news and commentary, visit tastylive.com or @tastyliveshow on YouTube

Trade with a better broker, open a tastytrade account today. tastylive, Inc. and tastytrade, Inc. are separate but affiliated companies.