Next U.S. Fed Rate Cut Could Bring $150 Oil

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Oil is going up faster than gold. Both are leaving the dollar in the dust. Oil set its 9th new high in the last ten trading sessions. The front-month futures contract traded at US$108.21 in New York.

Why is oil sprinting past gold? Both are hedges against inflation and U.S. dollar weakness. But in simple terms, it’s easier for large players to be long oil than long gold. Crude oil futures are the most actively traded contracts in the commodities market. If you want a quick trade, that’s where you go.

Any port in a storm, goes the old saying. Oil and gold make a nice port. Keep an eye on the trade, though. It’s getting crowded. There are three phases to any bull market. The first stage is the undervalued stage, when an asset class bottoms and nobody notices. That is the best time to buy. It has long since passed.

The next stage sees the price go up to where future earnings are fully valued in the current price. The stock is neither cheap nor dear. This was probably 2004-2006.

Then comes the insanity, where a stock keeps going up because it keeps going it. People buy it simply because it’s rising. We are getting close to that stage with oil and gold. A big factor in how they go from here is how much lower the dollar can go. Between now and next Tuesday, it may go even lower.

The Fed meets next Tuesday to decide on rates. Judging by the futures markets, investors expect the Fed to cut rates 50 or 70 basis points. You’re probably seeing the oil market price that in. We’d expect the oil price to come back a bit when, in fact, the Fed does cut rates. However these blow-off phases in bull markets can overshoot massively. That would leave oil… well… we’d put a number out there like $150, but you’d just laugh.

There is not much to laugh about if you’re Ben Bernanke though. It’s not clear another rate cute will slow down the deterioration in the banking sector. The value of collateral keeps falling. Banks want their money back. Leveraged speculators have to sell to raise cash.

And as we mentioned yesterday, there is one extremely worrisome development that could rock the global financial markets to their foundations. Yes, it’s been pretty bad up to now. But the government sponsored enterprises (GSEs) in the U.S., Fannie Mae and Freddie Mac, together guarantee over US$4.2 trillion in mortgages.

Incredibly, and by that we mean “not credibly”, the GSEs have not sustained the same level of losses in their mortgage portfolios as the banks have. Fannie lost US$3.6 billion in the fourth quarter and Freddie $2.5. Both had to raise more capital. But compared to the banks, these losses are remarkably small.

But here’s the thing… the first wave of bad subprime debt came from mortgages originated in 2004. The delinquencies and defaults on those loans have been enough to cost the financial sector over $150 billion in losses. It’s brought the credit market to its knees.

The horrible news for investors is that loans originated in 2005 and 2006 already have much higher delinquency rates. They will have higher default rates, too. The last in to the boom will be some of the first out.

Over US$600 billion in lower-credit quality loans were originated in 2005 and 2006. Already about 5% of loans made in 2006 are more than 90-days delinquent on payments. It’s not a shocker when you think about it. At the height of the boom, anyone could get a mortgage. But what this means is that the loans made in 2005 and 2006 at the peak of America’s housing boom could be the worst performing of the whole subprime lot.

The shocking performance of these 2005 and 2006 loans hasn’t been factored into stock prices yet. We would also suggest that no one yet know how the mortgage portfolio of the GSEs is going to hold up this year. The idea that asset quality at the GSEs may become an issue this year is simply too scary for most investors to contemplate.

GSEs sell bonds to finance purchases of mortgages in the secondary market. The GSE bond market was larger, for a period, than the U.S. Treasury market. Central banks, pension funds, banks… everyone owns agency-backed bonds (as GSE bonds are called.) If those bonds continue to fall in value, this whole mess reaches a new, truly scary phase.

Where is it all headed? Eventually the Fed is going to have quit selling money cheap and start buying mortgages. We reckon the Fed will have to directly buy GSE debt in the near future. The liquidity issues in the financial sector will only finally be solved when all the suspect, infected, and putrid mortgage debt is either written off or finds a permanent home. The Fed is likely to be that home, fulfilling its mission of buyer of last resort (along with lender of last resort.)

Naturally, loading up America’s national balance sheet with the accumulated mal-investments from the housing bubble is not going to be a good thing for the U.S. dollar. While the oil price looks a little frothy on its own, when you account for the potential damage to the dollar from the “nationalization” of the mortgage market, well… you ain’t seen nothing yet.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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The fact that a falling US dollar means the US will be constantly outbid by the EU and other nations in the oil market doesn’t seem to have sunk in to the US public in general. The fact is that the further the US dollar falls, oil becomes relatively more affordable for countries whose currencies are strengthening against the dollar and more expensive for the US and countries whose currencies are tied to the dollar (e.g. China). The consequences will be very interesting to watch.

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