Crude Oil Inflation Spiral

27 Sep 2022

With crude oil prices declining, one might expect that the Federal Reserve's monetary tightening is working and that perhaps a pivot may be on the horizon. However, if we dig deeper, charts are sending warning signs that perhaps crude oil prices, and inflation in general, might remain elevated for much longer than expected.


The chart above is a monthly chart of Brent Crude Oil adjusted in price by the Japanese Yen.

In the chart, we see what appears to be a double top.



However, unlike during the Great Recession, in the current situation, the price of crude oil has fallen much less quickly after peaking. Compare the two charts below.



When priced in Japanese Yen, crude oil is 80% higher today than where it was after peaking in 2008 (the red ghost bars below show the 2008 price action). In other words, crude oil prices have declined much slower after their current peak than after their peak in 2008.



Ominously, a bull pennant appears on the monthly chart.



Although I do not have Fibonacci levels applied to this chart, the bull pennant structure is a perfect golden ratio retracement. Such a perfect bull pennant pattern could suggest that crude oil prices (adjusted in Japanese Yen) may break above resistance and continue higher, rather than decline at all.


Why might this be happening?

The Bank of Japan continues to maintain negative interest rates. Negative interest rates is just an obfuscated way of saying it continues to produce more and more money. Negative interest rates result in limitless money being produced through credit. Negative interest rates therefore cause money to become less and less scarce over time. Less scarcity of money always ultimately results in inflation. This continued monetary easing in turn weakens the Yen relative to currencies of countries with higher interest rates, especially the rapidly strengthening U.S. dollar.



Since Japan is too highly indebted to hike interest rates at all, let alone at the pace that the U.S. Federal Reserve is hiking rates, Japan is facing a crisis whereby the value of its currency is rapidly weakening.




Instead of hiking interest rates to mitigate its weakening currency, the Bank of Japan has chosen to sell U.S. Treasuries to increase its supply of dollars, and to buy Yen with those dollars. While this action may help Japan avert an energy shortage by providing the U.S. dollars needed to ensure a steady flow of crude oil, by increasing its supply of U.S. dollars, Japan also perpetuates commodity inflation. More supply of U.S. dollars keeps crude oil, which is priced in U.S. dollars, higher for longer.

The more U.S. Treasuries Japan sells, the more U.S. dollars it will have to continue paying high crude oil prices, which in turn keeps inflation higher for longer, which in turn causes the U.S. Federal Reserve to hike rates more for even longer to bring commodity inflation down. Since the Bank of Japan is unable to hike rates the Yen in turn slides further. This negative feedback loop can spiral into a monetary and economic crisis if unabated.


How bad could the situation get?

To find the answer to this question, we can examine the yearly chart for Brent Crude Oil. Below is the yearly chart.



Notice that the Stochastic RSI is indicating that Brent Crude Oil prices have strong upward momentum on the yearly chart. When oscillators push strongly higher on the yearly timeframe, this can lead to a prolonged period of sustained higher prices. The best way to hypothesize a potential peak is to use Fibonacci extensions on the yearly chart.



If commodity inflation persists, then price may undergo Fibonacci extension on the yearly chart. This process will be slow and insidious with periods of commodity prices coming down as they retrace on lower timeframes, such that bull rallies trap unsuspecting market participants who believe that the era of limitless monetary easing will soon return. Monetary easing cannot return or else the commodity inflation spiral worsens. Indeed, spiraling inflation puts central banks in a Catch-22 whereby any action they can take results in economic decline.

Only time will tell how this Catch-22 will end, but I will leave you with one final chart, shown below.



This chart shows a regression channel that measures how far above or below its mean crude oil is currently priced when compared to its entire 160-year price history. What's alarming is that despite the rapid rise in crude oil prices, we are merely just now reach the mean (red line). If history repeats itself, price could double, triple or more from current levels in the years to come...