Positive/Negative Feedback Loop

Unwinding ZIRP carry trades turned a slow Monday into a hot trading day. The media focused on S&P, Debt and the Equity markets but somehow missed oil. We believe it is the oil market that will ultimately call the tune in this phase of the credit cycle. The oil rally started innocently enough on economic growth data. The MENA situations changed the story to geo-political. The Fed is counting on oil (gasoline) to slow the economy but not reverse the expansion. If prices were to fall to the 80-90 level of winter, the Fed could find itself in a worse position.

Lower energy costs would spur confidence and ease headline inflation over time. These positives could, in a twisted feedback loop, put the Fed farther behind the curve than present. Conversely, monetizing the oil shock reduces the probability of lower prices without significant economic pullback. One thing is for sure, there is no shortage of black gold.

The debt ceiling and deficit fights will be nastier now that S&P moved publicly. The Administration showed its hand when Obama (most likely an unopposed incumbent) kicked off the campaign early. Tax increases will play a bigger role in negotiations. The capital markets will keep score by the minute. Greenspan always included the question "What causes inflation?" in his quizzes. Long and varied answers were marked down for one response, Excess government spending. The Clinton/Rubin budgets were designed to exploit this belief. If they cut, the Fed would keep credit flowing.  Oddly, Bernanke has promised the latter without movement on the former. The feedback loops are getting loopier.

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