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Crude Rate Cuts And Market Schizophrenia.

  • Written by Syndicated Publisher 60 Comments60 Comments Comments
    June 24, 2011

    Good afternoon.  Quick synopsis of macro-thoughts.  I’m not used to writing market comments or market updates anymore given the all things government and policy impacts on markets.  It seems too often that it was as simple as the Treasury is selling the Fed is buying.  And that was it.  Simple.

    The markets have been weighing degrees of stimulus for years now, Tarps, Talfs, QE2s, stabilization funds, foreign exchange gimmicks.  Today is another sort of stimulus.  To some degree, we have seen a first today, unprecedented coordination to lower a commodity price, and possibly for political reasons.  The IEA, a Paris based research arm of 28 industrialized countries, held an emergency press conference to announce its members would release 60 million barrels onto the market.

    It is only the third time IEA tapped reserves, the first was during 1991 Gulf War, then again when Hurricane Katrina wiped out some production in the Gulf of Mexico.  The U.S. topped the operation off by releasing an additional 30mm barrels from the Strategic Petroleum Reserve.

    There is a surreal irony in the fact that policy coordinations used to be in the form of global FX interventions.  Years ago, for the youngsters, there used to be a term that would resonate in the FX markets.  The term was “dirty float” and it was used commonly on FX desks as globally coordinated FX interventions.  When I started in the business in early 90s it was common to have central banks globally coordinate to buy US dollars.  The dollar was under attack and was trading at all time lows of 78 dollars to yen.  This was Rob Rubinesque fare as a voice of calm on the pulpit to defend the dollar.

    In bond markets, central banks used to often coordinate rate cuts and rate hikes.  Again, in the early 90s the Fed was finishing a decade plus long string of rate cuts that culminated in a 1% Fed Funds rate.  Often, central banks would cut rates in tandem.  U.S., Bundesbank (before ECB), France, Netherlands etc.  We have seen our fair share of unconventional policies and coordinated policies in recent years and now we see globally coordinated strategic oil releases.

    There was considerable discussion on trading floors, blogs, maybe even the streets, that this is a political function, releasing oil for strategic political reasons.  Elections and economies.  Oil used to be and can be viewed as a representation of inflation.  Not only higher transportation gas costs but the commodity is in many products globally and its input can drive the marginal cost of a product.

    But at a level oil becomes a tax, and elasticity of demand function whereby consumers have less discretionary cash flow as a result of higher fuel and energy costs choking off consumption.  Some accuse the executive office of now having figured out as James Carville once said, “It’s the economy, stupid.”  Maybe not Libya, which is another political concept anyway.

    There even has been some linkages made to Fed Chairman Bernanke who increasingly has been exposing the sensitivities or LIMITATIONS of conducting monetary in a fiscal world.  A world of debt limit debates, global business confidence impacts, refusal to invest corporate monies on sidelines confidence impacts, stimulus package impacts.  Heck, the Chairman gave a speech on June 14th called “Fiscal Sustainability”.  An odd topic for MONETARY wonk.

    Today’s events in oil should be considered the equivalent of a global coordinated rate cut.  I view oil in long run as an inflationary headwind but I view elevated prices at the moment as more of a consumption tax and price shock.   Today’s events may merely be temporary (as China is likely luring to buy EVERY available barrel) but I think they will serve a psychological and pocket purpose of lubricating conditions.

    J-curve, an economics text book concept of the first reaction being the opposite of intermediate term or longer term reaction.  I feel risk asset and equity responses today as J-curve.  Why?

    In the globalization of markets and the evolution of markets, asset performance has become correlated.  Some times, often during downturns, assets tend to become more correlated but I think no one can deny the fact that there is a delta correlation in most asset classes often.  The pursuit of alpha lends to creative hedging strategies.  CDX index sell mortgage, HY sell NASDAQ, Hedge tips buy selling oil.  Get hit on Pepsi sell Coke, HIT OIL: SELL EQUITIES.  J-curve.

    I believe the equity space is getting hit today as a risk correlation.  Risk on: risk off.  Equities are a natural byproduct of hedging oil risk, commodity risk and vice versa.  There is a beta.

    However, lower oil price should be a boon to consumption and a boon to equities.  We may be able to claim Middle East policy but how do you get more stimulus with the timing of a Federal Reserve press conference where Chairman’s opine?  What do you do when you have zero interest rates and at zero you have bumped up against the lower boundary of perceived traditionally explicit policy of rate cuts?  You find other stimulus.

    Ask the tips market.  There was a $7 billion 30 year tips auction today that came 4 bps through the market.  Calculate the $1226 value of a basis point times 4 bps ($4904) per million times market share bid?  Dealers aspire to set shorts to buy supply.  $7 billion bonds means $34 billion street P&L hit for dealers. 26.1% direct bidders which means players bypassed the street.  But why?  Oil was down over $4 at the time and that this TIPS buying may read oil moves as STIMULATIVE.  Equities got it wrong earlier on sophisticated correlation trading.  World of opposites but I think this correlation will be short lived.  Different players expressed different views in tips and other risk assets today.

    So, I view today’s news as a significant positive for equities and, hence, less so for bonds.  Funny that the oil declines COULD be the unintended straw that breaks the bond market’s back.  But to no avail today.  Russ

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