INTERFERNCE REVERSION
EDU DDA May 1, 2025
Summary: OPEC’s action and oil’s fall didn’t happen in isolation, nor were they unexpected. WTI closely corresponds with a range of financial signals starting with bond yields (2s!) and swap spreads. As much as central banks have been interfering in rates like the cartel in oil, it could never last given the growing deflationary confidence coming from the deep fundamentals. Knowing how and why OPEC and central banks get these wrong simply confirmed the eventuality. That collision on display yesterday in Riyadh was again on display today in Tokyo. BoJ moved one step closer to truth.
THE END OF AN ERA, WITH MAJOR IMPLICATIONS.
The Bank of Japan was the odd one out. Japan had emerged from the lockdowns later than almost everywhere else meaning that the price pressures of the supply shock were coiled up waiting loner for their moment. It came in April 2022 right in time for the oil price spike which was then followed by the yen’s near-collapse (Japan had to pay for increasingly expensive dollars to buy all that higher-priced oil and food).
Where BoJ’s peers have been pivoting in the other direction over the last year, Governor Ueda has been trying to save the yen from wreaking more havoc on the Japanese economy. Officially classified an “inflation” fight, it’s not, just another price imbalance these pseudo-central banks are not equipped to handle. This doesn’t stop them from telling everyone different.
What good would three small interest rate increases end up being? We’re really supposed to believe going from slightly negative overnight rates to positive fifty basis points and maybe even seventy-five is somehow going to restrain purportedly titanic price imbalances. As was once asked of Christine Lagarde in Europe, how are policy rates going to get more oil out of the ground?
For Japan, relief along those lines is on the way. Oil, as noted yesterday, set a new multi-year low with OPEC more openly embracing recession economics by removing the last critical supply support from global prices. Though weaker energy costs are welcome, it’s only on narrow grounds, given why oil is doing what it is doing to the point crude suppliers are forced finally to fall in line.
For the BoJ, its policy meeting earlier today concluded with a raft of “dovishness” which has any further rate hikes on hold. Yields fell in the JGB market as a result of less interference from Ueda for the time being. A key reason for the soft switch in stance is how Japan’s economic situation is beginning to resemble the oil market’s.
While blaming tariffs is understandable, and there is some connection, this was the direction the world was taking long before them. After all, one only need to see the close correlations between fundamentals in finance, money and then the real economy to appreciate the inexorable pull of all this gravity. From swaps to ST Treasury yields, WTI corresponds with each of them so it was really only a matter of time before Japan finds itself doing what OPEC just did.
Background in theory
The same as central banks interfering with interest rates, so OPEC’s intervention with supply was doomed from the start. Mistaking a forgot how to grow recession for growth was only the first mistake. That’s the problem with creating policies grounded in Economics rather than economics.
The former is forced to employ a backwards, reverse-engineered approach on everything starting with inflation. To begin with, it is assumed price acceleration is akin and equivalent to economic growth – the bathtub approach espoused from Keynesians like Larry Summers or Krugman. Basically, the believe inflation results from when economic growth is too much for potential, therefore the water in the tub overtops and spills over as inflation.
This belief covers everything we do and say on the topic, even coloring the language we use to describe it – red-hot economy creates red-hot prices and so on. There is no room for the supply shock case. Not only do central bankers (as Economists) worry the mere act of price increases can lead to more price increases (expectations theory), they also have no other way to eliminate legitimate inflation as a possibility.
Since real inflation is always and everywhere a monetary phenomenon, the monetary realm would be the first – and only – place to go looking for answers. However, central bankers can’t do this; they wouldn’t know where to even start.
They are hardly alone with this blind spot. We have the same problem they do, though we seek a different route to derive answers and analysis.
Economists look to the macroeconomy. Since inflation is driven by monetary conditions, yet they don’t know what those are, Economists look backward at the “inflation” which results, and then make inferences from it as needed. It sounds reasonable: if CPIs are accelerating, then assume there might be some money behind it. Should CPIs start being tamed, then perhaps the monetary system might have calmed down and maybe because of slightly higher interest rates.
But if you can’t sort legit inflation in consumer prices from supply shocks and assorted economic (small “e”) imbalances, confusion is bound to result (and this is a distinct matter from whether or not interest rates can even impact the monetary system and economy to do something productive about inflation were it to ever show up). All they see is a CPI on the rise, having no other choice officials put it down as inflationary.
Our solution to the same lack of money information is at least more direct. Peering as close to the blackhole as possible, we look to market cues for evidence. We may not be able to measure the amount of eurodollars in the world, that’s not really what we’re after anyway. The key to it all isn’t supply so much as it is circulation.
Market signals are far from perfect though they do provide a rough yet usable framework. And these are mainly focused on movement, circulation, elasticity, all the primary and relevant indications.
Central bankers and Economists (same thing) avoid doing this since they don’t trust market signals or prices, preferring instead econometric models that are closer to their own worldview (why they always fail). In reality, they simply can’t make sense of anything well enough to make use of them.
Background in practice
Oil prices aren’t solely a key source of consumer price agitation. They are, in financial terms, grounded in the real economy while also relating closely enough to the monetary one. The three factors guiding crude markets are demand for energy, the supply of it, then the ease of leverage and financing.
Surprising perhaps to many people, starting with every central banker, oil prices correspond strongly to monetary signals such as bond yields and swap spreads (plus a whole lot more). Not only are there common financial aspects between all these, monetary circulation itself is an input into economic conditions – deflationary circumstances can, and too often are, a drag on the real economy, therefore one key component to WTI and Brent.
It also can work in the other direction. Since so much of monetary circulation in the post-crisis era is itself sensitive to perceptions of economic potential, a slowdown in it can lead to risk aversion among monetary participants thereby reducing elasticity as a reflection of growing concerns over the macroeconomy; which would also be oil-price negative.
There needn’t be any mechanical relationships between the bond or interest rate swap market and the electronic futures pits where crude and energy transact. Both key variables are looking at the same things from different angles, one purely financial and the other some of that plus also grounded in the real economy. That each consistently comes to the same conclusions is what makes these relationships so compelling only a central banker would ignore them.
BOTH OIL AND 2s HAVE HAD TO CONTEND WITH INTERFERENCE WHILE ALSO PRICING FUNDAMENTALS
Since the summer of 2022, WTI has therefore corresponded very closely with the yield on the 2-year Treasury. Since the 2s are the link on the yield curve between the long end’s independent growth and inflation expectations and central bank interference at the front end, the correlation with oil prices adds another layer to the set of signals.
This isn’t really an “inflation” angle, either. What I mean is, the 2s aren’t pricing oil as a CPI variable and therefore extrapolating WTI into a central bank policy framework. If oil goes up, then CPIs will accelerate and lead to higher central bank policy rates, therefore the 2s link WTI to Jay Powell given how those like Powell work backward as described above.
No, the market is looking at conditions in the monetary system and real economy same as oil traders. When coming to the same conclusions the implications for central bank interest rate policies become clear given enough time. What oil and bonds are picking up on today will eventually force officials’ hands.
The swap market provides the final and damning proof. Negative swap spreads from 2022 onward have been consistently more deflationary even as, for central banks and their policies, they’ve been driven chasing inflation that isn’t inflation. That’s what the swap market is, the next best thing to direct monetary observation, an indication that closely relates to all the fundamental operations which go into money circulation globally coming from deep within the system itself.
NEITHER OIL NOR INTEREST RATES HAD A CHANCE, HELD UP MAINLY BY CONUFSED CENTRAL BANKS AND THE CARTEL
Swaps have looked past the interference of both central banks as well as OPEC. The former have obviously been impeding interest rates whereas the latter, more in line with swaps, has been holding back supply to try to support oil prices as a means to offset economic weakness consistent with compressing negative swaps spreads. Rates were higher than they “should” have been, and so were oil prices.
And so the 2s and WTI have been correlated while both became somewhat uncorrelated from swaps at least in the intermediate term.
Therefore, from the position of the swap market, both rates and oil were far more likely than not to end up going lower where true fundamentals have had them. Sure enough, over the last year both have been going that way. There was no legit inflation nor recovery, the end result being a fragile economy waiting for the combination of short run negatives to break it all down far enough even OPEC and the Fed would have no choice but to finally get out of the way and let oil and ST rates reflect the deflationary consequences.
Now the BoJ
Japan, as stated at the outset, has been a laggard in this cycle. The BoJ has been hiking rates as a matter of “inflation” as commonly understood by Economics and forecast in econometric models. So long as CPIs are rising too quickly, central bankers believe they have no choice except react; only until the real economic fundamentals finally overwhelm them.
That point is still in the future for the Fed, and to an extent BoJ, too, even if it has already arrived for OPEC (as discussed in yesterday’s DDA). However, BoJ took a very clear step in that direction, not necessarily with its policy hold, instead the data-based reasons for it.
First off, the Japanese models radically lowered growth projections for the first quarter then the full year overall. As to the latter, BoJ slashed its forecast for real GDP in CY2025 to 0.5% (between 0.4% and 0.6%) from the 1.1% (0.9% to 1.1%) estimation made just four months ago in January. They can claim uncertainty all they want, or that the models were unable to account for the negatives for “trade wars”, but there weren’t many of those in Q1.
Analysts have since come to the consensus Japan like the United States will have experienced a small negative for GDP during the first three months of the year – before trade restrictions. To begin with, like their global counterparts, Japanese officials made the mistake of falling for the artificial high last year, thinking it genuine economic acceleration when it was anything but (again, market signals).
The payback instead began during Q1 highlighting the underlying fragility in monetary and economic systems even before getting to tariffs. Outside sources are also pointing to a high probability Q2 contracts at an even stronger pace, and if so putting Japan into a “technical recession” that wouldn’t be just technical, it would be entirely consistent with the deflationary transition the entire world has been slowly moving toward the entire time.
Industrial Production for March, for example, came in down sharply, especially in the auto business. After a modest rise late last year, payback hit hard on the month, with output in the sector crashing by 8%. For the quarter as a whole, IP was down yet again, falling more than 1% - pointing this out one more time, before tariffs. It will only get worse from here, and central bankers know it, and that’s why they’ve dramatically scaled back economic projections to the point it has changed at least the near-term rate interference outlook.
NOT EXACTLY BOOMTIMES OVER THERE IN JAPAN BEFORE ‘TRADE WARS’
Officials or the media can point to trade war “uncertainty” all they like, market signals have been consistent for a long before that the global economy was getting to be in an increasingly fragile state. Removing the interference in especially oil prices would have better revealed this; what would’ve everyone said and thought had oil been in the $50s last year rather than $70s?
The monetary system we’d find out since both the economy and oil were really on that course anyway.
That’s the one final irony in this mess. Central bank policies, like OPEC’s supply restrictions, both were intended on creating productive stability. Instead, they led to each group fooling themselves, first, and then counterproductively becoming a source of great uncertainty.
Swaps and other markets said that wouldn’t last. OPEC is done. BoJ is moving there. Eventually, the Fed, too.
